Bank of N.Y. Mellon v. Comm'r Am. Int'l Grp., Inc. v. United States
This text of Bank of N.Y. Mellon v. Comm'r Am. Int'l Grp., Inc. v. United States (Bank of N.Y. Mellon v. Comm'r Am. Int'l Grp., Inc. v. United States) is published on Counsel Stack Legal Research, covering Court of Appeals for the Second Circuit primary law. Counsel Stack provides free access to over 12 million legal documents including statutes, case law, regulations, and constitutions.
Opinion
14‐704‐ag(L), 14‐765‐cv Bank of N.Y. Mellon v. Commʹr; Am. Intʹl Grp., Inc. v. United States 14‐704‐ag(L), 14‐765‐cv Bank of N.Y. Mellon v. Commʹr; Am. Intʹl Grp., Inc. v. United States
UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
August Term 2014
(Argued: May 18, 2015 Decided: September 9, 2015)
Docket Nos. 14‐704‐ag(L), 14‐1394‐ag(XAP), 14‐765‐cv
THE BANK OF NEW YORK MELLON CORPORATION, as Successor in Interest to THE BANK OF NEW YORK COMPANY, INC.,
Petitioner‐Appellant‐Cross‐Appellee,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent‐Appellee‐Cross‐Appellant.
AMERICAN INTERNATIONAL GROUP, INC.,
Plaintiff‐Appellant,
UNITED STATES OF AMERICA,
Defendant‐Appellee.
ON APPEAL FROM THE UNITED STATES TAX COURT AND THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK
Before: CABRANES, RAGGI, and CHIN, Circuit Judges.
Appeals and cross‐appeal heard in tandem from a judgment of the
United States Tax Court (Kroupa, J.) and an opinion and order of the United
States District Court for the Southern District of New York (Stanton, J.) applying
the ʺeconomic substance doctrineʺ to transactions involving foreign tax credits.
The Tax Court considered the effect of foreign taxes in its pre‐tax analysis and
denied the claimed foreign tax credits as lacking economic substance, but
allowed interest expense deductions for the loan associated with the transactions.
The district court held that the economic substance doctrine applies to
transactions involving foreign tax credits generally and that foreign taxes are to
be included in calculating pre‐tax profit.
AFFIRMED.
‐ 2 ‐ SETH P. WAXMAN (Catherine M.A. Carroll, Weili J. Shaw, Jonathan A. Bressler, William J. Perlstein, Alan E. Schoenfeld, Roger M. Ritt, Richard W. Giuliani, on the brief), Wilmer Cutler Pickering Hale and Dorr LLP, Washington, DC, New York, New York, and Boston, Massachusetts, for Petitioner‐Appellant‐Cross‐Appellee Bank of New York Mellon Corporation.
JUDITH A. HAGLEY, Tax Division, Department of Justice (Gilbert S. Rothenberg, Richard Farber, Tax Division, Department of Justice, on the brief), for Tamara W. Ashford, Acting Assistant Attorney General, Washington, DC, for Respondent‐Appellee‐ Cross‐Appellant Commissioner of Internal Revenue.
DAVID BOIES (Robin A. Henry, Edward J. Normand, on the brief), Boies, Schiller & Flexner LLP, Armonk, New York, and Thomas A. Cullinan, Jerome B. Libin, Daniel H. Schlueter, Sutherland Asbill & Brennan LLP, Atlanta, Georgia, and Washington, DC, for Plaintiff‐Appellant American International Group, Inc.
JOSEPH N. CORDARO, Assistant United States Attorney (James Nicholas Boeving, Benjamin H. Torrance, Assistant United States Attorneys, on the brief), for Preet Bharara, United States Attorney for the Southern District of New York, New York, New York, for Defendant‐Appellee United States of America.
Scott P. Martin, Geoffrey C. Weien, Gibson, Dunn & Crutcher LLP, Washington, DC, and Kate Comerford Todd, Steven P. Lehotsky, U.S. Chamber Litigation Center, Inc., Washington, DC,
‐ 3 ‐ for Amicus Curiae United States Chamber of Commerce.
Martin S. Kaufman, Larchmont, New York, for Amicus Curiae Atlantic Legal Foundation.
CHIN, Circuit Judge:
These appeals and cross‐appeal, heard in tandem, challenge an
opinion and order of the United States District Court for the Southern District of
New York (Stanton, J.) and a judgment of the United States Tax Court (Kroupa,
J.) applying the ʺeconomic substance doctrineʺ to transactions involving foreign
tax credits. In both cases, the taxpayers claim they are entitled to tax credits
associated with foreign transactions that the government disallowed because it
contends the transactions lacked economic substance.
In American International Group., Inc. v. United States, in which
American International Group (ʺAIGʺ) seeks a tax refund of $306.1 million, the
district court held that: 1) the economic substance doctrine applies to the foreign
tax credit regime; and 2) the pre‐tax benefit that AIG gained from its ʺcross‐
borderʺ transactions is to be calculated by taking into account foreign taxes.
Accordingly, the district court denied AIGʹs motion for partial summary
judgment. It certified the matter for interlocutory appeal.
‐ 4 ‐ In Bank of New York Mellon Corp. v. Commissioner, which involves
alleged tax deficiencies of some $215 million, the Tax Court held a three‐week
bench trial on the economic substance of the Structured Trust Advantaged
Repackaged Securities loan product (ʺSTARSʺ) purchased by Bank of New York
Mellon (ʺBNYʺ). The Tax Court held: 1) the effect of foreign taxes is to be
considered in the pre‐tax analysis of economic substance; and 2) STARS lacked
economic substance, and thus BNY could not claim foreign tax credits associated
with STARS. The Tax Court further held that certain income from STARS was
includible in BNYʹs taxable income and BNY was not entitled to deduct interest
expenses associated with STARS, but reversed both rulings on reconsideration.
We hold that the economic substance doctrine applies to the foreign
tax credit regime generally, and that both the district court and Tax Court
properly determined the tax implications of the cross‐border and STARS
transactions. Accordingly, we affirm.
STATEMENT OF THE CASE
A. The Foreign Tax Credit Regime
Various provisions of the Internal Revenue Code (the ʺCodeʺ) seek
ʺto mitigate the evil of double taxation.ʺ Burnet v. Chi. Portrait Co., 285 U.S. 1, 7
‐ 5 ‐ (1932). The Code taxes all income of U.S. taxpayers earned worldwide. 26 U.S.C.
§ 61(a). Because this can result in double taxation of a U.S. taxpayerʹs income
earned abroad ‐‐ by the country in which it was earned as well as the United
States ‐‐ Congress crafted the ʺforeign tax creditʺ regime.
First established by the Revenue Act of 1918, the foreign tax credit
regime was intended to facilitate business abroad and foreign trade. See 56
Cong. Rec. app. 677 (1918) (statement of Rep. Kitchin) (ʺWe would discourage
men from going out after commerce and business in different countries . . . if we
maintained this double taxation.ʺ). Under the regime, when a U.S. taxpayer pays
income tax to another country due to its business activities in that country, the
taxpayer can claim a dollar‐for‐dollar credit against its U.S. tax liability for the
foreign taxes paid. 26 U.S.C. §§ 901‐909. This ʺforeign tax creditʺ then mitigates
double taxation by offsetting the taxpayerʹs U.S. taxable income and reducing its
overall tax bill. The foreign tax credit regime does not, however, require a
taxpayer ʺto alter its form of doing business, its business conduct, or the form of
any business transaction in order to reduce its liability under foreign law for tax.ʺ
26 C.F.R. § 1.901‐2(e)(5)(i).
‐ 6 ‐ As relevant to the instant cases, the Code deems taxes paid by
foreign subsidiaries to be paid by their U.S. parent companies. 26 U.S.C. §§ 902,
960. Thus, in a given tax year, a U.S. corporation can claim a ʺforeign tax creditʺ
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14‐704‐ag(L), 14‐765‐cv Bank of N.Y. Mellon v. Commʹr; Am. Intʹl Grp., Inc. v. United States 14‐704‐ag(L), 14‐765‐cv Bank of N.Y. Mellon v. Commʹr; Am. Intʹl Grp., Inc. v. United States
UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT
August Term 2014
(Argued: May 18, 2015 Decided: September 9, 2015)
Docket Nos. 14‐704‐ag(L), 14‐1394‐ag(XAP), 14‐765‐cv
THE BANK OF NEW YORK MELLON CORPORATION, as Successor in Interest to THE BANK OF NEW YORK COMPANY, INC.,
Petitioner‐Appellant‐Cross‐Appellee,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent‐Appellee‐Cross‐Appellant.
AMERICAN INTERNATIONAL GROUP, INC.,
Plaintiff‐Appellant,
UNITED STATES OF AMERICA,
Defendant‐Appellee.
ON APPEAL FROM THE UNITED STATES TAX COURT AND THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK
Before: CABRANES, RAGGI, and CHIN, Circuit Judges.
Appeals and cross‐appeal heard in tandem from a judgment of the
United States Tax Court (Kroupa, J.) and an opinion and order of the United
States District Court for the Southern District of New York (Stanton, J.) applying
the ʺeconomic substance doctrineʺ to transactions involving foreign tax credits.
The Tax Court considered the effect of foreign taxes in its pre‐tax analysis and
denied the claimed foreign tax credits as lacking economic substance, but
allowed interest expense deductions for the loan associated with the transactions.
The district court held that the economic substance doctrine applies to
transactions involving foreign tax credits generally and that foreign taxes are to
be included in calculating pre‐tax profit.
AFFIRMED.
‐ 2 ‐ SETH P. WAXMAN (Catherine M.A. Carroll, Weili J. Shaw, Jonathan A. Bressler, William J. Perlstein, Alan E. Schoenfeld, Roger M. Ritt, Richard W. Giuliani, on the brief), Wilmer Cutler Pickering Hale and Dorr LLP, Washington, DC, New York, New York, and Boston, Massachusetts, for Petitioner‐Appellant‐Cross‐Appellee Bank of New York Mellon Corporation.
JUDITH A. HAGLEY, Tax Division, Department of Justice (Gilbert S. Rothenberg, Richard Farber, Tax Division, Department of Justice, on the brief), for Tamara W. Ashford, Acting Assistant Attorney General, Washington, DC, for Respondent‐Appellee‐ Cross‐Appellant Commissioner of Internal Revenue.
DAVID BOIES (Robin A. Henry, Edward J. Normand, on the brief), Boies, Schiller & Flexner LLP, Armonk, New York, and Thomas A. Cullinan, Jerome B. Libin, Daniel H. Schlueter, Sutherland Asbill & Brennan LLP, Atlanta, Georgia, and Washington, DC, for Plaintiff‐Appellant American International Group, Inc.
JOSEPH N. CORDARO, Assistant United States Attorney (James Nicholas Boeving, Benjamin H. Torrance, Assistant United States Attorneys, on the brief), for Preet Bharara, United States Attorney for the Southern District of New York, New York, New York, for Defendant‐Appellee United States of America.
Scott P. Martin, Geoffrey C. Weien, Gibson, Dunn & Crutcher LLP, Washington, DC, and Kate Comerford Todd, Steven P. Lehotsky, U.S. Chamber Litigation Center, Inc., Washington, DC,
‐ 3 ‐ for Amicus Curiae United States Chamber of Commerce.
Martin S. Kaufman, Larchmont, New York, for Amicus Curiae Atlantic Legal Foundation.
CHIN, Circuit Judge:
These appeals and cross‐appeal, heard in tandem, challenge an
opinion and order of the United States District Court for the Southern District of
New York (Stanton, J.) and a judgment of the United States Tax Court (Kroupa,
J.) applying the ʺeconomic substance doctrineʺ to transactions involving foreign
tax credits. In both cases, the taxpayers claim they are entitled to tax credits
associated with foreign transactions that the government disallowed because it
contends the transactions lacked economic substance.
In American International Group., Inc. v. United States, in which
American International Group (ʺAIGʺ) seeks a tax refund of $306.1 million, the
district court held that: 1) the economic substance doctrine applies to the foreign
tax credit regime; and 2) the pre‐tax benefit that AIG gained from its ʺcross‐
borderʺ transactions is to be calculated by taking into account foreign taxes.
Accordingly, the district court denied AIGʹs motion for partial summary
judgment. It certified the matter for interlocutory appeal.
‐ 4 ‐ In Bank of New York Mellon Corp. v. Commissioner, which involves
alleged tax deficiencies of some $215 million, the Tax Court held a three‐week
bench trial on the economic substance of the Structured Trust Advantaged
Repackaged Securities loan product (ʺSTARSʺ) purchased by Bank of New York
Mellon (ʺBNYʺ). The Tax Court held: 1) the effect of foreign taxes is to be
considered in the pre‐tax analysis of economic substance; and 2) STARS lacked
economic substance, and thus BNY could not claim foreign tax credits associated
with STARS. The Tax Court further held that certain income from STARS was
includible in BNYʹs taxable income and BNY was not entitled to deduct interest
expenses associated with STARS, but reversed both rulings on reconsideration.
We hold that the economic substance doctrine applies to the foreign
tax credit regime generally, and that both the district court and Tax Court
properly determined the tax implications of the cross‐border and STARS
transactions. Accordingly, we affirm.
STATEMENT OF THE CASE
A. The Foreign Tax Credit Regime
Various provisions of the Internal Revenue Code (the ʺCodeʺ) seek
ʺto mitigate the evil of double taxation.ʺ Burnet v. Chi. Portrait Co., 285 U.S. 1, 7
‐ 5 ‐ (1932). The Code taxes all income of U.S. taxpayers earned worldwide. 26 U.S.C.
§ 61(a). Because this can result in double taxation of a U.S. taxpayerʹs income
earned abroad ‐‐ by the country in which it was earned as well as the United
States ‐‐ Congress crafted the ʺforeign tax creditʺ regime.
First established by the Revenue Act of 1918, the foreign tax credit
regime was intended to facilitate business abroad and foreign trade. See 56
Cong. Rec. app. 677 (1918) (statement of Rep. Kitchin) (ʺWe would discourage
men from going out after commerce and business in different countries . . . if we
maintained this double taxation.ʺ). Under the regime, when a U.S. taxpayer pays
income tax to another country due to its business activities in that country, the
taxpayer can claim a dollar‐for‐dollar credit against its U.S. tax liability for the
foreign taxes paid. 26 U.S.C. §§ 901‐909. This ʺforeign tax creditʺ then mitigates
double taxation by offsetting the taxpayerʹs U.S. taxable income and reducing its
overall tax bill. The foreign tax credit regime does not, however, require a
taxpayer ʺto alter its form of doing business, its business conduct, or the form of
any business transaction in order to reduce its liability under foreign law for tax.ʺ
26 C.F.R. § 1.901‐2(e)(5)(i).
‐ 6 ‐ As relevant to the instant cases, the Code deems taxes paid by
foreign subsidiaries to be paid by their U.S. parent companies. 26 U.S.C. §§ 902,
960. Thus, in a given tax year, a U.S. corporation can claim a ʺforeign tax creditʺ
in the same amount as the foreign taxes paid by its foreign subsidiary, reducing
its total U.S. taxable income.
ʺEntitlement to foreign tax credits[, however,] is predicated on a
valid transaction.ʺ 12 Mertens Law of Federal Income Taxation § 45D:62. To be
ʺvalidʺ and not just a ʺsham,ʺ a transaction must involve more than just tax
benefits: it must have independent economic substance. See DeMartino v.
Commʹr, 862 F.2d 400, 406 (2d Cir. 1988) (ʺA transaction is a sham if it is fictitious
or if it has no business purpose or economic effect other than the creation of tax
deductions.ʺ). Accordingly, as we discuss below, a court can hold that a
taxpayer is not entitled to certain deductions or other tax benefits where it finds
that the underlying transaction lacks ʺeconomic substanceʺ beyond its tax
benefits.
‐ 7 ‐ B. American International Group, Inc. v. United States
1. The Facts
As AIG acknowledges, the facts relevant to this appeal are largely
undisputed.1 To the extent that there is dispute, we construe the facts in the light
most favorable to the non‐moving party, the government:
Between 1993 and 1997, AIG entered into six cross‐border
transactions with foreign financial institutions through its subsidiary, AIG
Financial Products (ʺAIG‐FPʺ).2 Through these transactions, AIG‐FP borrowed
funds at economically favorable rates below LIBOR and invested the funds at
rates above LIBOR, ostensibly to make a profit.3
1 The government never moved for summary judgment below and contends on appeal that a trial is necessary because genuine issues of material fact exist with respect to whether the cross‐border transactions have economic substance.
2 The names of the disputed transactions and their dates and counterparties are: ʺLaperouse,ʺ entered September 30, 1993 with Credit Agricole; ʺVespucci,ʺ entered December 18, 1995 with Banca Commerciale Italiana; ʺNZ Issuerʺ or ʺNew Zealand,ʺ entered December 11‐19, 1996 with Bank of New Zealand; ʺMaitengrove,ʺ entered February 28, 1997 with Bank of Ireland; ʺLumagrove,ʺ entered August 27, 1997 with Bank of Ireland; and ʺPalmgrove,ʺ entered October 20, 1997 with Irish Permanent.
3 LIBOR stands for ʺLondon Interbank Offered Rateʺ and is the benchmark rate that many banks charge each other for short‐term loans. See Carpenters Pension Tr. Fund of St. Louis v. Barclays PLC, 750 F.3d 227, 229, 230 n.2 (2d Cir. 2014).
‐ 8 ‐ Each cross‐border transaction operated as follows. First, AIG‐FP
created and funded a foreign affiliate ‐‐ a special purpose vehicle (ʺSPVʺ) ‐‐ to
hold and invest funds in a foreign country. Next, AIG‐FP sold the SPVʹs
preferred shares to a foreign lender bank and committed to repurchase the
preferred shares on a specific future date at the original sale price. The SPVʹs
capital was thus primarily comprised of the funds the foreign bank paid for the
preferred stock, as well as a smaller contribution from AIG. The SPV then used
this capital to purchase investments, earning income for which the SPV paid
taxes to the relevant foreign authority. The SPV then paid most of the net
proceeds of this investment income to the foreign bank as dividends.
For U.S. tax purposes, AIG claimed that it owned all of the shares of
the SPV and thus treated the foreign bankʹs funds for the purchase of the
preferred shares as a loan. AIG then deducted the dividends paid by the SPV to
the foreign banks as interest expense. AIG also claimed foreign tax credits for
the full amount of the foreign taxes paid by each SPV on the pre‐dividend
investment income. Accordingly, on its 1997 U.S. tax return, AIG reported total
gross income from the cross‐border transactions of $128.2 million from which it
deducted $71.9 million in interest expenses, for a net taxable income of $56.3
‐ 9 ‐ million. Based on the corporate tax rate of 35%, AIG owed $19.7 million in taxes
on the cross‐border transactions. But AIG also claimed $48.2 million in foreign
tax credits for the foreign taxes paid by the SPVs on total income, which it then
used to offset U.S. tax not only on its $19.7 million U.S. tax obligation for the
cross‐border transaction, but also on some $28.5 million in unrelated income.
At the same time, each foreign bank reported to the relevant foreign
revenue authority that it owned the preferred stock as an equity investment in
the SPV. As a result, for foreign tax purposes, the SPV was treated as the foreign
bankʹs corporate subsidiary. Accordingly, instead of treating the SPVʹs
distribution to the foreign bank as taxable interest on a loan to AIG, the foreign
bank claimed the payments as tax‐exempt dividends on which it paid little, if
any, tax. Instead, the SPV paid tax on the SPVʹs income to the relevant foreign
authorities. The foreign bank then shared these tax benefits with AIG‐FP by
accepting a lower dividend rate than it would have otherwise demanded if its
investment income were taxable
This arrangement effectively reduced AIGʹs total tax bill. It also
allowed the foreign banks to limit their tax liability, inducing them to accept
lower return rates from AIG. Thus, AIG effectively converted certain interest
‐ 10 ‐ expenses it otherwise would have paid to the foreign banks into foreign tax
payments for which it claimed foreign tax credits that it could use in turn to
offset unrelated income and reduce its total U.S. tax bill.
AIG claims that the cross‐border transactions had economic
substance because they were expected to generate a pre‐tax profit of at least
$168.8 million for AIG over the life of the transactions. To reach this number,
AIG calculated pre‐tax profit by taking the SPVʹs investment income and
subtracting only AIGʹs operating expenses and obligations to the foreign banks.
Thus, in calculating pre‐tax profit, AIG ignored: 1) the foreign tax paid by the
SPV; 2) the U.S. tax paid by AIG on the SPVʹs investment income; and 3) the
value of the foreign tax credits claimed by AIG.
2. Proceedings Below
On March 20, 2008, the Internal Revenue Service (the ʺIRSʺ) sent AIG
a Statutory Notice of Deficiency for its 1997‐1999 taxes. For the 1997 taxable year,
the notice claimed an additional income tax of $110.2 million, and interest,
penalties, or additions to tax of $12.6 million. Among other penalties and
assessments, the IRS disallowed the $48.2 million in foreign tax credits AIG
claimed in 1997. On July 8, 2008, the IRS assessed the additional amounts, which
‐ 11 ‐ AIG paid on August 1, 2008. On August 25, 2008, AIG filed a claim for refund
for the amounts paid, claiming they were erroneously assessed by the IRS. On
February 27, 2009, because the IRS had not rendered a decision on its refund
claim, AIG filed a complaint in the district court seeking a refund of $306.1
million in federal income taxes assessed by the IRS and paid by AIG for its 1997
taxable year.
On July 30, 2010, AIG moved for partial summary judgment,
arguing that it was entitled, as a matter of law, to foreign tax credits for the
income taxes paid to other countries by its subsidiaries. AIG argued that: 1) the
economic substance doctrine does not apply to the foreign tax credit regime; and
2) even if the doctrine does apply, the relevant transactions had economic
substance because they resulted in $168.8 million in pre‐tax profit. On March 29,
2011, the district court denied AIGʹs motion without prejudice, concluding that
the government had demonstrated the need for more discovery. After the close
of fact discovery but before the start of expert discovery, AIG renewed its motion
for partial summary judgment on August 1, 2012, limited to the six cross‐border
transactions.
‐ 12 ‐ On March 29, 2013, the district court issued an opinion and order
denying AIGʹs renewed motion for partial summary judgment. The district court
held that: 1) the economic substance doctrine applies to the foreign tax credit
regime because Congress intended foreign tax credits to facilitate only
ʺpurposiveʺ business transactions; and 2) foreign taxes are to be included as a
cost in the calculation of pre‐tax benefit from the cross‐border transactions.
Accordingly, the district court denied AIGʹs motion for partial summary
judgment. Am. Intʹl Grp., Inc. v. United States, No. 09 Civ. 1871(LLS), 2013 WL
1286193 (S.D.N.Y. Mar. 29, 2013).
On November 5, 2013, the district court certified its March 29, 2013
opinion and order for interlocutory appeal under 28 U.S.C. § 1292(b). On
November 15, 2013, AIG timely filed a petition in this Court for permission to
appeal under Federal Rule of Appellate Procedure 5(a)(2). On March 19, 2014,
we granted the petition, and this appeal followed.
‐ 13 ‐ C. Bank of New York Mellon v. Commissioner
We accept the facts as found by the Tax Court at trial unless clearly
erroneous. See Banker v. Nighswander, Martin & Mitchell, 37 F.3d 866, 870 (2d Cir.
1994).
In 2001, Barclays Bank, PLC ‐‐ a global financial services company
headquartered in London, United Kingdom ‐‐ and KPMG ‐‐ an audit, tax, and
advisory firm ‐‐ started promoting a loan product they called ʺStructured Trust
Advantaged Repackaged Securitiesʺ or ʺSTARSʺ to U.S. banks. In marketing
STARS to U.S. banks, KPMG explained that a U.K. counterparty ‐‐ here
Barclays ‐‐ would offer a ʺbelow market loan,ʺ the low cost of which would be
achieved through the ʺsharingʺ of certain U.K. and U.S. tax benefits generated by
the creation of a trust subject to U.K. taxation. BNY entered into STARS
transactions with Barclays in November 2001, and the transactions continued
until 2006.
We assume familiarity with the Tax Courtʹs opinion below, which
describes the structure of STARS in detail. The basic operation of the STARS
transactions can be summarized as follows. First, BNY created a Delaware trust
‐ 14 ‐ to which it contributed $7.8 billion in income‐producing assets. In exchange for
this contribution, BNY received nominal shares in the trust (class A and B units).
BNY agreed to install a U.K. resident as the trustee, so the trustʹs income would
be subject to U.K. taxation. BNY then paid tax on the trust to the United
Kingdom, and, in exchange, Barclays agreed to pay BNY a monthly amount
equal to half of the U.K. taxes BNY expected to pay on the trustʹs income ‐‐ the
so‐called ʺtax‐spread.ʺ
Next, Barclays purchased shares in the trust (class C and D units) for
$1.5 billion, effectively making a loan in that amount to BNY for the duration of
STARS through the trust structure. BNY agreed to repay the loan by purchasing
Barclayʹs trust units for approximately $1.5 billion at the end of five years. The
monthly interest rate on the loan was equal to one‐month LIBOR plus 30 basis
points, minus the aforementioned monthly tax‐spread. Under this structure,
Barclays made total net monthly payments to BNY of $82.6 million over the life
of STARS.
Throughout the five‐year duration of the STARS transactions, the
trust made monthly distributions of income via a circular, multi‐step process.
First, BNY distributed funds from its income‐earning assets to the trust, and the
‐ 15 ‐ trust set aside 22% of its income to pay U.K. taxes. With most of the remaining
income,4 the trust made monthly class C unit distributions to a Barclays account
that was ʺblocked,ʺ meaning Barclays could not access the funds or control the
account. Barclays immediately returned these distributions to the trust each
month, and the trust then distributed the funds to BNY, beginning the cycle
again.
The resulting tax benefits to both BNY and Barclays from STARS can
be illustrated by tracing a hypothetical $100 of trust income through the
distribution cycle (ignoring fees and the smaller class A, B, and D distributions).
See BNY Appellantʹs Br. at 14‐15; Salem Fin., Inc. v. United States, 786 F.3d 932, 938
(Fed. Cir. 2015) (employing similar hypothetical in reviewing STARS
transaction). Under U.K. tax law, Barclays ‐‐ as owner of the class C units ‐‐ was
deemed the owner of almost all of the trust income and taxed at the 30% U.K.
corporate tax rate, obligating it to pay $30 in tax for every $100 of trust income
($100 x 30%). Barclays would reduce this tax bill, however, by claiming a credit
for the 22% U.K. tax on the trust, which was paid by BNY. Barclaysʹ tax liability
4 Small quantities of the trust income were paid to BNY on the class A units (1% of trust income) and B units, to Barclays on the class D units, and towards other expenses.
‐ 16 ‐ for the trust income was thus only $8 ($30 ‐ $22). BNY, in turn, would claim a
foreign tax credit in the United States for the full $22 it had paid in U.K. taxes on
the trustʹs income.
The income distribution scheme compounded the tax benefits to
both parties. Each month, for every $100 of trust income, the trust would set
aside $22 to pay U.K. taxes, with $78 remaining for distribution. Because the $78
was first transferred to Barclaysʹ blocked account and then back to the trust,
Barclays could treat the re‐contributed $78 as a trading loss and claim a trading
loss deduction under U.K. tax law. At the 30% corporate tax rate, the deduction
translated to a $23.40 reduction in Barclaysʹ U.K. taxes ($78 x 30%). The
deduction more than offset Barclayʹs $8 tax bill from the trust, resulting in a net
tax benefit to Barclays of $15.40 ($23.40 ‐ $8). Finally, Barclays would pay the $11
tax‐spread to BNY ‐‐ half the trustʹs U.K. tax bill of $22. Because Barclays would
deduct the cost of the tax‐spread from its U.K. corporate taxes, it gained an
additional $3.30 in tax benefit ($11 x 30%). In the end, this left Barclays with
$7.70 in total tax benefit for each $100 of trust income ($15.40 minus the tax‐
spread payment of $11, plus the tax‐spread deduction of $3.30).
‐ 17 ‐ BNY also enjoyed a net tax benefit. While it paid $22 in U.K. taxes, it
was effectively reimbursed half this amount upon receipt of the $11 tax‐spread
from Barclays. Neverthless, it claimed the full $22 as a foreign tax credit in the
United States, for a total net gain of $11.
Meanwhile the United Kingdom and United States collected little to
no tax revenue on STARS. For each $100 of trust income, the United Kingdom
only collected $3.30 in net taxes ($22 in tax paid by BNY minus $18.70 ($15.40 +
$3.30) in tax benefits to Barclays). The United States collected no taxes from
STARS. Yet, for the tax years 2001 and 2002, BNY claimed foreign tax credits of
$198.9 million and interest expense deductions of $7.6 million that offset its
unrelated income and reduced its overall U.S. tax bill for these years.
On August 14, 2009, the IRS issued a Statutory Notice of Deficiency
to BNY of $100.5 million for its 2001 taxes and $115 million for its 2002 taxes,
disallowing foreign tax credits and interest expense deductions it had claimed
for those years. On November 10, 2009, BNY petitioned the Tax Court for a re‐
determination of deficiencies. BNY did not contest that the economic substance
‐ 18 ‐ doctrine applied to STARS but argued that STARS had economic substance, and
that therefore it was entitled to the claimed credits and deductions.
The Tax Court held a three‐week bench trial, and on February 11,
2013, issued an opinion holding that the STARS transactions were to be
disregarded for U.S. tax purposes. Bank of N.Y. Mellon Corp. v. Commʹr, 140 T.C.
15 (2013). The court bifurcated its analysis of the STARS trust structure and the
$1.5 billion loan and found, in relevant part: 1) foreign taxes but neither loan
proceeds nor the tax‐spread should be considered in the pre‐tax analysis of
economic substance; 2) the STARS trust transaction lacked economic substance,
as BNY had no purpose in entering the transaction except tax avoidance; 3) the
tax‐spread should be included in BNYʹs taxable income rather than considered a
component of loan interest, as it served as a device to monetize anticipated
foreign tax credits; and 4) all expenses incurred from the STARS transactions,
including interest expenses from the $1.5 billion loan, were not deductible.
On March 12, 2013, BNY moved for reconsideration of the Tax
Courtʹs rulings with respect to the tax‐spread as taxable income and interest
expense deductions. On September 23, 2013, the Tax Court issued a
supplemental opinion granting BNYʹs petition on these issues and held that 1)
‐ 19 ‐ the tax‐spread was not includible in BNYʹs income because it was part of the
trust transaction that was disregarded for tax purposes for lacking economic
substance; and 2) BNY was entitled to interest expense deductions because the
$1.5 billion loan, bifurcated from the STARS trust transaction, had independent
economic substance.
The Tax Court entered judgment on February 20, 2014. BNY
appealed, and the IRS cross‐appealed the Tax Courtʹs interest expense deduction
ruling on the $1.5 billion loan.
DISCUSSION
ʺThe general characterization of a transaction for tax purposes is a
question of law subject to review.ʺ Frank Lyon Co. v. United States, 435 U.S. 561,
581 n.16 (1978). We thus review the lower courtʹs characterization of a
transaction de novo, and where the lower court has made underlying factual
findings, we review those findings for clear error. See Jacobson v. Commʹr, 915
F.2d 832, 837 (2d Cir. 1990); Newman v. Commʹr, 902 F.2d 159, 162 (2d Cir. 1990).
We review a district courtʹs denial of a motion (or partial motion) for
summary judgment de novo. Doninger v. Niehoff, 642 F.3d 334, 344 (2d Cir. 2011).
ʺSummary judgment is proper only when, construing the evidence in the light
‐ 20 ‐ most favorable to the non‐movant, there is no genuine dispute as to any material
fact and the movant is entitled to judgment as a matter of law.ʺ Id. (internal
quotation marks omitted).
We address (a) the applicability of the economic substance doctrine
to the foreign tax credit regime generally; (b) the economic substance of the
transactions at issue in the instant cases; and (c) the deductibility of the interest
expenses BNY paid on the $1.5 billion loan from Barclays.
A. Applicability of the Economic Substance Doctrine to the Foreign Tax Credit Regime
The ʺeconomic substanceʺ doctrine is a common law rule that allows
courts to question the validity of a transaction and deny taxpayers benefits to
which they are technically entitled under the Code if the transaction at issue
lacks ʺeconomic substance.ʺ See Gregory v. Helvering, 293 U.S. 465, 468‐70 (1935).
The doctrine applies to ʺshamʺ transactions that ʺcan not with reason be said to
have purpose, substance, or utility apart from their anticipated tax
consequences.ʺ Goldstein v. Commʹr, 364 F.2d 734, 740 (2d Cir. 1966).
AIG argues that the economic substance doctrine cannot be applied
to disallow foreign tax credits that comply with all statutory and regulatory
‐ 21 ‐ requirements.5 AIG contends that because the congressional purpose of foreign
tax credits ‐‐ to prevent double taxation ‐‐ is clear, a court should never be able to
question a taxpayerʹs use of the credits under the economic substance doctrine.
See AIG Appellantʹs Br. at 23‐30; cf. Estelle Morris Trs. v. Commʹr, 51 T.C. 20, 43
(1968) (emphasizing need to limit doctrines like economic substance to
ʺsituations which they were intended to coverʺ).
We disagree. First, the Supreme Court has long held that ʺsubstance
rather than form determines tax consequences.ʺ Raymond v. United States, 355
F.3d 107, 108 (2d Cir. 2004) (quoting Cottage Sav. Assʹn v. Commʹr, 499 U.S. 554,
570 (1991) (Blackmun, J., dissenting)) (internal quotation marks omitted); see
Commʹr v. Court Holding Co., 324 U.S. 331, 334 (1945). As we have recognized, the
economic substance doctrine stems from the concern that ʺeven if a transactionʹs
form matches the dictionary definitions of each term used in the statutory
definition of the tax provision, it does not follow that Congress meant to cover
such a transaction and allow it a tax benefit.ʺ Altria Grp., Inc. v. United States, 658
F.3d 276, 284 (2d Cir. 2011) (internal quotation marks omitted).
5 BNY did not raise this argument in the tax court and does not develop it on appeal. To the extent BNY contests the doctrineʹs general applicability to foreign tax credits, we reject the argument for the same reasons we reject AIGʹs argument.
‐ 22 ‐ Second, AIG misconstrues the purpose behind the economic
substance doctrine. The economic substance doctrine exists to provide courts a
ʺsecond lookʺ to ensure that particular uses of tax benefits comply with
Congressʹs purpose in creating that benefit. See Gregory, 293 U.S. at 469
(observing that, to assess economic substance, a court must look to the purpose
of the statute to determine ʺwhether what was done . . . was the thing which the
statute intendedʺ). It is entirely appropriate for a court to ask, therefore, whether
a taxpayerʹs claim to foreign tax credits is tied to true ʺbusiness abroadʺ resulting
in actual out‐of‐pocket tax payments, or whether its claim to a tax credit derives
from sham transactions devoid of a business purpose beyond exploiting
differences among foreign tax codes. We have repeatedly acknowledged the
applicability of the economic substance doctrine to various ʺshamʺ transactions.
See, e.g., Jacobson, 915 F.2d at 837‐38; DeMartino v. Commʹr, 862 F.2d 400, 406‐07
(2d Cir. 1988); Diggs v. Commʹr, 281 F.2d 326, 329‐30 (2d Cir. 1960). Further,
under Gregory, ʺa taxpayer carr[ies] an unusually heavy burdenʺ in seeking to
show that anti‐abuse doctrines like economic substance do not apply to the
situation at hand. Diggs, 281 F.2d at 330.
‐ 23 ‐ Third, we find no support for the contention that foreign tax credits,
by their nature, are not reviewable for economic substance. Congressʹs intent in
creating foreign tax credits was to prevent double taxation of taxpayers
conducting business in the United States and abroad. H.R. Rep. 83‐1337, at 4103
(1954) (ʺThe provision was originally designed to produce uniformity of tax
burden among United States taxpayers, irrespective of whether they were
engaged in business in the United States or engaged in business abroad.ʺ). The
legislative history thus focuses on taxpayers engaged in foreign business.
Nothing in the history suggests that foreign tax credits are entitled to special
immunity from scrutiny under the general economic substance doctrine, which
allows a court to ask if a transaction really is ʺbusinessʺ within the meaning of
the Code. As we have emphasized, the foreign tax credit is designed only for the
taxpayer who ʺdesires to engage in purposive activity,ʺ not sham transactions
built solely around tax arbitrage. See Goldstein, 364 F.2d at 741 (emphasis added).
Fourth, recent amendments to the Code and its regulations ‐‐ while
not applicable to the instant cases, which predate these changes ‐‐ support our
interpretation of Congressʹs intent regarding economic substance. In 2010,
Congress codified the economic substance doctrine into the Code, recognizing
‐ 24 ‐ that ʺ[a] strictly rule‐based tax system cannot efficiently prescribe the appropriate
outcome of every conceivable transaction that might be devised and is, as a
result, incapable of preventing all unintended consequences.ʺ H.R. Rep. 111‐443,
pt. 1, at 295 (2010). This provision codified the two‐part economic substance test
used in many Circuits, including ours, and affirmed decades of judge‐made law
from around the country on economic substance. It did not create categorical
exceptions to the doctrine, for foreign tax credits or otherwise.
Further, the Treasury Department issued new regulations (proposed
in 2007, finalized in 2011) disallowing foreign tax credits associated with STARS
and other similarly convoluted transactions designed to take advantage of
foreign tax credits. Because the regulations are not retroactive, their preamble
addressed the problem of already existing STARS: ʺFor periods prior to the
effective date of final regulations, the IRS will continue to utilize all available
tools under current law to challenge the U.S. tax results claimed in connection
with such arrangements, including . . . the economic substance doctrine . . . .ʺ
Determining the Amount of Taxes Paid for Purposes of Section 901, 72 Fed. Reg.
15,081, 15,084 (Mar. 30, 2007). These amendments reflect both Congressʹs
‐ 25 ‐ recognition of the economic substance doctrine generally and its concern for
potential abuse of foreign tax credits.
We thus hold that the economic substance doctrine can, as a general
matter, be applied to disallow foreign tax credits.
B. Economic Substance Analysis
We turn to the transactions at issue in AIG and BNY and evaluate
them under our Circuitʹs test for economic substance.
1. Applicable Law
In determining whether a transaction lacks ʺeconomic substance,ʺ
we consider: 1) whether the taxpayer had an objectively reasonable expectation
of profit, apart from tax benefits, from the transaction; and 2) whether the
taxpayer had a subjective non‐tax business purpose in entering the transaction.
See Gilman v. Commʹr, 933 F.2d 143, 147‐48 (2d Cir. 1991). In our Circuit the test is
not a rigid two‐step process with discrete prongs; rather, we employ a ʺflexibleʺ
analysis where both prongs are factors to consider in the overall inquiry into a
transactionʹs practical economic effects. See id. at 148; Altria Grp., Inc. v. United
States, 694 F. Supp. 2d 259, 282 (S.D.N.Y. 2010), affʹd, 658 F.3d 276; Long Term
Capital Holdings v. United States, 330 F. Supp. 2d 122, 171 (D. Conn. 2004), affʹd,
‐ 26 ‐ 150 F. Appʹx 40 (2d Cir. 2005) (summary order).6 ʺ[A] finding of either a lack of a
business purpose other than tax avoidance or an absence of economic substance
beyond the creation of tax benefits can be but is not necessarily sufficient to
conclude the transaction a sham.ʺ Long Term Capital Holdings, 330 F. Supp. 2d at
171.7
The preliminary step of the economic substance inquiry is to identify
the transaction to be analyzed. Even if the transaction at issue is part of a larger
series of steps, ʺ[t]he relevant inquiry is whether the transaction that generated
the claimed deductions . . . had economic substance.ʺ Nicole Rose Corp. v.
Commʹr, 320 F.3d 282, 284 (2d Cir. 2003); see Long Term Capital Holdings, 330 F.
6 It has been suggested that there is some confusion in our Circuit regarding whether our test for economic substance is a ʺflexibleʺ two‐part inquiry where neither factor is dispositive, or whether a taxpayer can show either an objective economic effect or a subjective business purpose to demonstrate economic substance. See TIFD III‐E Inc. v. United States, 342 F. Supp. 2d 94, 108‐09 (D. Conn. 2004), revʹd on other grounds, 459 F.3d 220 (2d Cir. 2006) (highlighting ʺambiguityʺ that ʺdecisions in this circuit are not perfectly explicit on the subject,ʺ but declining to decide which test applies). We have, however, consistently applied the flexible approach. See Gilman, 933 F.2d at 148.
7 Congress codified the economic substance doctrine in 2010, explicitly adopting a version of the two‐part test: ʺIn the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if ‐‐ (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayerʹs economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.ʺ 26 U.S.C. § 7701(o)(1). Because the provision is not retroactive, the Codeʹs test does not apply in these cases.
‐ 27 ‐ Supp. 2d at 183 (holding that a taxpayer ʺcannot avoid the requirements of
economic substance simply by coupling a routine economic transaction
generating substantial profits and with no inherent tax benefits to a unique
transaction that otherwise has no hope of turning a profitʺ).
After isolating the relevant transaction, we begin our analysis of
economic substance by determining the objective economic substance of the
transaction at issue. We then look to the taxpayerʹs subjective business purpose
in entering the transaction. Finally, we consider both the objective and subjective
analysis to make a final determination of economic substance. See Gilman, 933
F.2d at 148.
a. Objective Economic Substance
The focus of the objective inquiry is whether the transaction ʺoffers a
reasonable opportunity for economic profit, that is, profit exclusive of tax
benefits.ʺ Gilman, 933 F.2d at 146 (internal quotation marks omitted). As
relevant here, our Circuit has yet to determine how profit should be calculated
when a transaction involves foreign tax credits. The question is whether, for
purposes of the economic substance doctrine, foreign taxes should be treated as
costs when calculating pre‐tax profit. If the answer is yes, then a transaction will
‐ 28 ‐ be less likely to appear profitable under the objective prong of the economic
substance test.
Other Circuits have taken disparate approaches. In Salem Financial,
Inc. v. United States, a case involving the same STARS transactions at issue in
BNY, the Federal Circuit concluded that foreign taxes are economic costs that are
properly deducted in assessing profitability for the purposes of economic
substance. There, as with BNY here, the court determined that for every $100 of
trust income, the bank incurred $22 of foreign tax expense and only $11 in
income from the tax‐spread, for an $11 net loss. 786 F.3d at 946‐49. The court
also excluded foreign tax credits from the profit calculation, observing that ʺ[o]ur
precedent, like that of several other courts, supports the governmentʹs approach,
i.e., to assess a transactionʹs economic reality, and in particular its profit
potential, independent of the expected tax benefits.ʺ Id. at 948. Because the
Federal Circuit included foreign tax costs ‐‐ but excluded any foreign tax benefits
‐‐ in its calculation of pre‐tax profit, the court concluded that the trust transaction
in STARS was ʺprofitless.ʺ Id. at 949.
The Federal Circuit held, however, that this lack of post‐foreign‐tax
profit did not conclusively establish that a transaction lacks objective economic
‐ 29 ‐ substance. Id. at 950. The Court ultimately held that STARS lacked objective
economic substance, based on both the lack of post‐foreign‐tax profit and on the
circular cash flows through the trust whose only purpose was generating tax
benefits. Id. at 950‐51.8 Indeed, the court recognized that, as a result, the U.S.
taxpayer was reimbursed for half the U.K. tax it had paid by a U.K. STARS
counterparty who could claim foreign tax benefits that significantly reduced the
net revenues realized by the U.K. from STARS. See id. Thus, the scheme was not
objectively profitable and there was no real risk of double taxation, the purpose
for which U.S. law afforded a foreign tax credit.
In factually different contexts, the Fifth and Eighth Circuits have
taken a different approach to assessing objective economic substance, holding
that foreign taxes are not economic costs and should not be deducted from pre‐
tax profit. Compaq Comput. Corp. & Subsidiaries v. Commʹr, 277 F.3d 778 (5th Cir.
2001), revʹg, 113 T.C. 214 (1999); IES Indus., Inc. v. United States, 253 F.3d 350 (8th
Cir. 2001), revʹg, No. C97‐206, 1999 WL 973538 (N.D. Iowa Sept. 22, 1999). In both
8 Barclays entered into STARS transactions with six U.S. banks, and two other cases addressing the economic substance of STARS are pending. Santander Holdings USA, Inc. v. United States, 977 F. Supp. 2d 46, 53 (D. Mass. 2013) (holding that STARS had economic substance) (other claims still pending, including the governmentʹs alternative arguments for disallowing the tax benefits of STARS); Wells Fargo & Co. v. United States, No. 09‐cv‐2764 (D. Minn.) (currently conducting pre‐trial motions).
‐ 30 ‐ cases, taxpayers purchased publicly traded foreign securities known as American
Depository Receipts (ʺADRsʺ) at market prices immediately before the securities
were to pay out dividends. Because the securities dividends were subject to a
15% foreign tax, they were priced at the market price plus 85% of the expected
dividend. The taxpayer/buyer received 85% of the dividend and quickly resold
the securities for market price back to the seller, sustaining a ʺlossʺ because the
post‐dividend market price of the securities was lower than the original purchase
price. The taxpayer then claimed capital loss deductions in the United States, as
well as foreign tax credits for the 15% foreign tax paid on the dividend. See
Compaq, 277 F.3d at 779‐80; IES, 253 F.3d at 352.
In analyzing the profitability of these transactions, both the Compaq
and IES courts declined to consider the foreign taxes paid and foreign tax credits
claimed in their economic substance analysis. Rather, the courts calculated
profitability based on the gross dividend, before foreign taxes were paid.
Compaq, 277 F.3d at 785; IES, 253 F.3d at 353‐54. Accordingly, the Eighth Circuit
awarded IES summary judgment on its tax refund claim because the ADR
transactions did not lack economic substance or a business purpose as a matter of
law. 253 F.3d at 356. The Fifth Circuit in Compaq reversed the Tax Court below,
‐ 31 ‐ holding that it erred in ignoring Compaqʹs pre‐tax profit on the ADRs. 277 F.3d
at 784.
The court in Compaq also faulted the Tax Court below for including
foreign taxes paid but not foreign tax credits claimed in its calculation of pre‐tax
profit. ʺTo be consistent, the analysis should either count all tax law effects or
not count any of them. To count them only when they subtract from cash flow is
to stack the deck against finding the transaction profitable.ʺ Compaq, 277 F.3d at
785; see also IES, 253 F.3d at 354.
The Tax Court in BNY acknowledged that its holding was
inconsistent with Compaq and IES but noted that it was not bound by either
decision. Emphasizing that neither the Supreme Court nor our Circuit had yet
addressed the issue, the Tax Court considered the effect of foreign taxes in its
objective economic substance analysis:
Economically, foreign taxes are the same as any other transaction cost. And we cannot find any conclusive reason for treating them differently here, especially because substantially all of the foreign taxes giving rise to the foreign tax credits stemmed from economically meaningless activity, i.e., the pre‐ arranged circular cashflows engaged in by the trust.
Additionally, excluding the economic effect of foreign taxes from the pre‐tax analysis would fundamentally undermine the point of the economic substance inquiry. That
‐ 32 ‐ point is to remove the challenged tax benefit and evaluate whether the relevant transaction makes economic sense.
140 T.C. at 35 n.9. Similarly, the Federal Circuit in Salem, decided after the Tax
Courtʹs decision in BNY, disagreed with the reasoning in Compaq and IES. The
court in Salem concluded that the Tax Courtʹs method of calculation reflects the
core principles of the economic substance doctrine:
The critical question is not whether the transaction would produce a net gain after all tax effects are taken into consideration; instead, the pertinent questions are whether the transaction has real economic effects apart from its tax effects, whether the transaction was motivated only by tax considerations, and whether the transaction is the sort that Congress intended to be the beneficiary of the foreign tax credit provision.
786 F.3d at 948. The court also emphasized that profit for purposes of ʺeconomic
substanceʺ must be analyzed within the context of the tax implications: ʺEven if
there is some prospect of profit, that is not enough to give a transaction economic
substance if the prospect of a non‐tax return is grossly disproportionate to the tax
benefits that are expected to flow from the transaction.ʺ Id. at 949.
We agree with the Tax Court in BNY and the Federal Circuit in
Salem. The purpose of calculating pre‐tax profit in this context is not to perform
mere financial accounting, subtracting costs from revenue on a spreadsheet: It is
‐ 33 ‐ to discern, as a matter of law, whether a transaction meaningfully alters a
taxpayerʹs economic position other than with respect to tax consequences. The
motivation behind the economic substance inquiry ʺis to ensure that tax benefits
are available only if ʹthere is a genuine multiple‐party transaction with economic
substance which is compelled or encouraged by business or regulatory realities,
is imbued with tax‐independent considerations, and is not shaped solely by tax‐
avoidance features that have meaningless labels attached.ʹʺ Id. (quoting Frank
Lyon, 435 U.S. at 583‐84). The doctrine was born out of necessity, as ʺ[e]ven the
smartest drafters of legislation and regulation cannot be expected to anticipate
every [tax avoidance] device.ʺ ASA Investerings Pʹship v. Commʹr, 201 F.3d 505,
513 (D.C. Cir. 2000). It is therefore appropriate for a court, when assessing the
objective economic substance of a transaction, to include the foreign taxes paid
but to exclude the foreign tax credits claimed in calculating pre‐tax profit.
We are mindful, as was the district court in certifying the AIG case
for interlocutory appeal, Am. Intʹl Grp., Inc. v. United States, No. 09 Civ.
1871(LLS), 2013 WL 7121184, at *3 (S.D.N.Y. Nov. 5, 2013), that some
commentators have criticized this approach, accusing courts of blindly ʺbuying
intoʺ the governmentʹs ʺsmoke and mirrorsʺ argument or ʺcontortingʺ the
‐ 34 ‐ economic substance doctrine ʺbeyond any recognizable bounds.ʺ9 Including
foreign taxes in calculating pre‐tax profit is inappropriate, they argue, because
the transactions are motivated by foreign tax benefits to foreign lenders, not by
U.S. tax benefits for U.S. borrowers. Further, they contend, this method of
calculation ʺfictionalizesʺ the transactions, including the costs of the transactions
but not the corresponding income.
We find these arguments unpersuasive. The purpose of the foreign
tax credit is to facilitate global commerce by making the IRS indifferent as to
whether a business transaction occurs in this country or in another, not to
facilitate international tax arbitrage. The transactions in both AIG and BNY were
structured to benefit foreign lenders but they were also structured to benefit U.S.
borrowers. Indeed, in BNY, Barclays paid the tax‐spread to BNY to share the
U.K. tax benefits of STARS between the parties at the same time that BNY sought
a foreign tax credit in an amount greater than that which ‐‐ after payment of the
tax‐spread ‐‐ it was actually out of pocket. In both cases, funds were treated as a
9 See Kevin Dolan, The Foreign Tax Credit Diaries ‐‐ Litigation Run Amok, 71 Tax Notes Intʹl 831, 833‐34, 836 (2013); Richard M. Lipton, BNY & AIG ‐‐ Using Economic Substance to Attack Transactions the Courts Do Not Like, 119 J. Tax 40, 46 (2013); Jason Yen & Patrick Sigmon, District Courtʹs ʺAIGʺ Ruling Expands Application of Economic Substance Doctrine in Unexpected Ways for Transactions Generating Excess Foreign Tax Credits, Daily Tax Rep., May 2, 2013. But see Michael S. Knoll, Compaq Redux: Implicit Taxes and the Question of Pre‐Tax Profit, 26 Va. Tax Rev. 821 (2007).
‐ 35 ‐ ʺloanʺ for U.S. tax purposes but as equity for foreign tax purposes solely to
minimize tax in both countries. Hence, the transactions themselves ʺfictionalizeʺ
the concept of international trade. In BNY, for example, funds contributed to a
U.S. trust that never left the United States were nonetheless subjected to U.K.
taxation because BNY installed a nominal U.K. trustee. Further, the trust
distributions were briefly transferred to a Barclays blocked account, then
immediately transferred back to the trust simply to trigger certain tax
consequences. Similarly, in AIG, the SPVs had no real employees or business
purpose of their own beyond creating tax benefits for the both the lender and
borrower.
While the transactions are certainly ʺrealʺ insofar as real money
changed hands, they are most appropriately characterized as ʺshamsʺ under the
economic substance doctrine, taken to avoid taxes. As discussed in more detail
below, the trust transaction in BNY had little to no potential for economic return
apart from the tax benefits. And when the record in AIG is viewed most
favorably to the government, a reasonable factfinder could reach the same
conclusion as to the cross‐border transactions. Accordingly, we hold that foreign
‐ 36 ‐ taxes are economic costs for purposes of the economic substance doctrine and
thus should be deducted from profit before calculating pre‐tax profit.
The objective economic substance inquiry, however, does not end at
profit, as a legitimate transaction could conceivably lack economic profit. See
Salem, 786 F.3d at 950 (ʺTransactions involving nascent technologies, for instance,
often do not turn a profit in the early years unless tax benefits are accounted for.
To brand such transactions as a sham simply because they are unprofitable
before tax benefits are taken into account would be contrary to the clear intent of
Congress.ʺ (citing Sacks v. Commʹr, 69 F.3d 982, 990‐92 (9th Cir.1995))). The
Supreme Court has indeed cautioned: ʺThere is no simple device available to
peel away the form of [a] transaction and to reveal its substance.ʺ Frank Lyon, 435
U.S. at 576. A court should also look to the overall economic effect of the
transaction in determining objective economic substance. In conducting this
inquiry, we agree with the Tax Court that ʺ[e]conomic benefits that would result
independent of a transaction do not constitute a non‐tax benefit for purposes of
testing its economic substance.ʺ Bank of N.Y. Mellon, 140 T.C. at 36‐37.
Determining whether a given transaction has economic substance under the
objective prong therefore requires both a calculation of pre‐tax profit and a
‐ 37 ‐ consideration of the transactionʹs overall economic effect. Accordingly, the
overall determination of objective economic substance is a question of fact.
b. Subjective Economic Substance
Apart from the objective inquiry, a court must also look to the
subjective business purpose of a transaction to determine whether it has
economic substance. Under the subjective inquiry, a court asks whether the
taxpayer has a legitimate, non‐tax business purpose for entering into the
transaction. See id. at 37; Long Term Capital Holdings, 330 F. Supp. 2d at 186. ʺThe
business purpose inquiry ʹconcerns the motives of the taxpayer in entering the
transaction;ʹ it asks whether the taxpayerʹs ʹsole motivationʹ for entering a
transaction was to realize tax benefits.ʺ Altria, 694 F. Supp. 2d at 281 (quoting
Riceʹs Toyota World, Inc. v. Commʹr, 752 F.2d 89, 92 (4th Cir. 1985)). The focus is
the reasonableness of the transaction and can be articulated as: would ʺa prudent
investor,ʺ absent tax benefits, ʺhave made the deal?ʺ See Long Term Capital
Holdings, 330 F. Supp. 2d at 186. This inquiry is, by nature, factual.
‐ 38 ‐ 2. Application
a. AIG
AIG argues that, as a matter of law, even if the economic substance
doctrine applies generally to foreign tax credits, the cross‐border transactions
had economic substance. To support this argument, AIG points to its calculated
$168.8 million in pre‐tax profit, a calculation that ignores the foreign taxes paid
by the SPV, the U.S. tax paid by AIG on the SPVʹs investment income, and the
foreign tax credits claimed by AIG. The district court acknowledged that ʺ[i]f the
computation of that figure proves correct, AIG would be entitled to judgment,ʺ
but ultimately rejected AIGʹs method and accordingly found that AIG was not
entitled to partial summary judgment. Am. Intʹl Grp., 2013 WL 1286193, at *5.
We agree that there are disputed issues of material fact as to both the
objective and subjective economic substance of the cross‐border transactions.
The district court therefore properly denied AIGʹs motion for partial summary
judgment. There is sufficient evidence in the record from which a reasonable
factfinder could conclude, as the government contends, that the transactions
lacked economic substance.
‐ 39 ‐ Under the objective prong, there are unresolved material questions
of fact regarding the overall economic effect of the cross‐border transactions and
the reasonableness of AIGʹs expectation of non‐tax benefits ‐‐ indeed, expert
discovery has not yet commenced in this case. The governmentʹs economist, Dr.
Michael Cragg, has done preliminary analysis of the transactions, and for the
purposes of its summary judgment motion, AIG did not contest his calculations.
Id. at *6. According to Dr. Cragg, ʺ[a]side from the tax benefits, the transactions
involved little, if any, potential for economic return,ʺ as ʺabsent the claimed tax
benefits, the transactions neither generated material economic returns for AIG,
nor offered the potential for such returns, after accounting for dividend
payments, operating expenses, and foreign taxes.ʺ AIG App. at 2353, 2360. Dr.
Cragg thus concluded that the ʺtransaction structure inflated the foreign tax
liabilities of the SPVs and generated income from tax benefits for AIG at the
direct expense of the United States.ʺ Id. at 2356. Further, the SPVs had no
substantive business activities of their own and absent capital contributions from
AIG, they would not have had sufficient cash flow to cover their expenses or pay
out dividends. Overall, the value of the foreign tax credits produced far
exceeded any independent potential for economic return from the cross‐border
‐ 40 ‐ transactions. Insofar as AIG contends that, in considering the transactionʹs
profitability, the district court inappropriately deducted the foreign taxes paid by
the SPV, we reject that argument in light of our holding that, as a matter of law,
foreign taxes are properly deducted in assessing a transactionʹs pre‐tax
profitability. Accordingly, a reasonable factfinder could conclude that the
transactions lacked objective economic substance.
Under the subjective prong, there are also material questions of fact
regarding AIGʹs business purpose for entering the cross‐border transactions. As
the government highlights, AIGʹs own internal documents described the cross‐
border transactions as ʺtax drivenʺ and ʺtax based deal[s].ʺ Id. at 2315, 2317.
Similarly, a foreign purchaser of a cross‐border transaction acknowledged ʺ[t]he
benefit to AIG comes from US tax laws whereby they can obtain a credit for the
tax paid in [the foreign country] and a deduction for the . . . dividend paid. The
tax credit effectively reduces their cost of borrowing . . . .ʺ Id. at 2319. Further,
AIG‐FP retained the right to terminate the transactions due to ʺchanges in tax
lawʺ or if AIG could not ʺsoak up the excess foreign tax credits.ʺ Id. at 2320.
Accordingly, a reasonable factfinder could conclude that AIG lacked a legitimate,
non‐tax business purpose in entering the transactions.
‐ 41 ‐ Thus, viewing the evidence in the light most favorable to the
government, as the non‐moving party, we hold that the government offered
sufficient evidence to permit a reasonable factfinder to find in its favor. Hence,
the district court did not err in denying partial summary judgment. See, e.g.,
Black & Decker Corp. v. United States, 436 F.3d 431, 442 (4th Cir. 2006) (reversing
summary judgment to taxpayer where IRS presented evidence from experts
showing transaction at issue lacked economic substance).
b. BNY
Like AIG, BNY argues that as a matter of law, STARS had economic
substance. BNY points to the $1.5 billion loan from Barclays as proof of
economic substance, and maintains that although tax benefits were part of its
motivation for entering STARS, this does not negate the transactionʹs economic
substance. BNY contends that the Tax Court erred in calculating pre‐tax profit
by: 1) bifurcating its analysis of the trust transaction and the $1.5 billion loan and,
as a result, excluding the amount BNY expected to earn by investing the loan
proceeds; 2) counting the foreign taxes paid as a cost; and 3) disregarding the
tax‐spread.
‐ 42 ‐ We conclude that the Tax Court committed no error. First, the Tax
Court appropriately bifurcated its analysis of the STARS trust transaction from
the $1.5 billion loan. As we have held, ʺ[t]he relevant inquiry is whether the
transaction that generated the claimed deductions . . . had economic substance.ʺ
Nicole Rose, 320 F.3d at 284. We agree with the Tax Court that ʺthe requirements
of the economic substance doctrine are not avoided simply by coupling a routine
transaction with a transaction lacking economic substance.ʺ Bank of N.Y. Mellon,
140 T.C. at 34; see Long Term Capital Holdings, 330 F. Supp. 2d at 183 (quoting
Nicole Rose).10 In BNYʹs case, the disputed tax benefits for the trust transaction
and the loan are distinct: foreign tax credits versus interest expense deductions.
We thus cannot say that the Tax Court erred in analyzing the transactions
separately.
Second, the Tax Court did not err in its calculation of the trust
transactionʹs objective economic substance. Because it considered the trust
10 Congress, when codifying the economic substance doctrine, further supported this interpretation by noting that under present law, courts could ʺbifurcate a transaction in which independent activities with non‐tax objectives are combined with an unrelated item having only tax‐avoidance objectives in order to disallow those tax‐ motivated benefits.ʺ Staff of J. Comm. on Taxation, 111th Cong., Technical Explanation of the Revenue Provisions of the ʺReconciliation Act of 2010,ʺ as Amended, in Combination with the ʺPatient Protection and Affordable Care Act,ʺ 153 & n.352 (J. Comm. Print 2010).
‐ 43 ‐ transaction separately from the loan, the Tax Court properly excluded the loan
proceeds BNY expected to earn by investing the loan proceeds from its
calculation of the trust transactionʹs profit. Further, in light of our holding that,
as a matter of law, foreign taxes should be deducted when calculating pre‐tax
profit, the Tax Court did not err in considering foreign taxes paid by BNY on
behalf of the trust and in concluding that the trust did not offer a reasonable
opportunity for economic profit because, as demonstrated in the hypothetical
above, for every $100 in trust income, BNY incurred a $22 loss by paying foreign
taxes.
Finally, in considering the overall economic effect of the transaction,
the district court did not err in excluding the tax‐spread that Barclays paid BNY
from calculated profit. The Tax Court found that the tax‐spread was a ʺtax
effect . . . . serv[ing] as a device for monetizing and transferring the value of
anticipated foreign tax credits generated from routing income through the
STARS structure.ʺ Bank of N.Y. Mellon, 140 T.C. at 43. BNY itself referred to the
tax‐spread as a ʺrebate from Barclaysʺ which Barclays paid to share the tax
benefits of STARS with BNY. BNY App. at 1525. Moreover, as BNY concedes,
the parties agreed that the tax‐spread would be half of the pre‐tax value of
‐ 44 ‐ Barclaysʹ expected U.K. tax benefits, which amounted to $11 for every $100 of
trust income. Thus, even offsetting BNYʹs foreign tax payment of $22 with the
tax‐spread, BNY still lost $11 for every $100 of trust income. The Tax Court
therefore reasonably concluded that ʺregardless of how the spread is
characterized, the benefit of the spread was more than offset by the additional
transaction costs that BNY incurred to obtain the spread.ʺ Bank of N.Y. Mellon,
140 T.C. at 43 n.15.
As noted above, the objective economic substance analysis does not
end at profit, and the Tax Court here appropriately considered other aspects of
the trust transaction to assess economic substance. Notably, the Tax Court found
that the transactionʹs circular cash flow strongly indicated that its main purpose
was to generate tax benefits for BNY and Barclays. See Altria, 658 F.3d at 289; see
also Salem, 786 F.3d at 950 (affirming trial courtʹs conclusion that STARS
transaction ʺlacked economic realityʺ in part because the transaction ʺconsisted of
ʹthree principal circular cash flows,ʹ which, apart from their intended tax
consequences, had no real economic effect.ʺ).
Indeed, this circular cash flow demonstrates that BNY, far from
risking double taxation, used an extremely convoluted transaction structure to
‐ 45 ‐ take maximum advantage of U.S. and U.K. tax benefits. BNY was reimbursed for
half of its U.K. tax payments and simultaneously claimed a foreign tax credit in
the United States for the full payment amounts. Toward this end, BNY created a
trust in the United States whose funds never left the United States; yet BNY
installed a nominal U.K. trustee precisely so the trust would be subject to U.K.
taxation. The trustʹs distribution structure makes little sense except in light of the
tax implications: each month funds were briefly sent to a blocked Barclays
account then immediately returned to the trust. The purpose of this two‐step
process was to allow Barclays to claim a U.K. tax loss while BNY could claim a
U.S. foreign tax credit. Because this structure allowed Barclays to recover the
cost of U.K. taxes paid by BNY, Barclays shared the tax benefits with BNY by
paying BNY the tax‐spread.
Third, the Tax Court did not err in finding that STARS lacked a
subjective business purpose beyond tax avoidance. The Tax Court found that the
STARS structure lacked a reasonable relationship to BNYʹs claimed business
purposes and BNYʹs interest in STARS was entirely predicated on the tax
benefits it involved. Bank of N.Y. Mellon, 140 T.C. at 38‐40. BNY asserted that the
business purpose for entering into the STARS transaction was to obtain a low‐
‐ 46 ‐ cost loan from Barclays. Id. at 40. The loan, however, was only ʺlow‐costʺ if the
tax‐spread was considered a component of the loan interest. The Tax Court
reasonably concluded that the tax‐spread should not be so considered because,
although the tax‐spread was netted against the interest BNY owed on the loan,
there was no real relationship between the two. Id. at 42. Rather, the tax‐spread
was a way for Barclays to share half of the pre‐tax value of its expected U.K. tax
benefits with BNY, and thus allow BNY to obtain $2 of foreign tax credit for each
$1 of expenditure. Bank of N.Y. Mellon, 140 T.C. at 41‐43. Absent this sharing of
tax benefits, BNYʹs loan ‐‐ with a monthly interest of one‐month LIBOR plus 30
basis points ‐‐ was not ʺlow costʺ because BNY could otherwise have borrowed
money at or below LIBOR. Further support for the Tax Courtʹs determination
that BNYʹs singular motivation was the two‐for‐one tax benefit is evident in
BNYʹs global tax directorʹs acknowledgment that KPMG ʺknew that if I wasnʹt
comfortable with our overall tax position and our ability to use those [foreign
tax] credits, then the transaction wouldnʹt get off the ground.ʺ BNY App. at 363.
Accordingly, considering the objective and subjective prongs of our
Circuitʹs flexible economic substance test together, we hold that the Tax Court
correctly concluded that the STARS trust transaction lacked economic substance.
‐ 47 ‐ C. Deductibility of Interest Expenses
The Code permits the deduction of ʺall interest paid or accrued
within the taxable year on indebtedness.ʺ 26 U.S.C. § 163(a). Thus, a taxpayer is
ordinarily entitled to deduct interest paid on indebtedness, reducing its taxable
income for a given year. See Lee v. Commʹr, 155 F.3d 584, 586 (2d Cir. 1998).
ʺInterest payments are not deductible[, however,] if they arise from transactions
that can not with reason be said to have purpose, substance, or utility apart from
their anticipated tax consequences. Such transactions are said to lack economic
substance.ʺ Id. (citation omitted) (internal quotation marks omitted). We have
repeatedly held that an interest deduction is not allowed if the interest payment
arises from a transaction that is economically empty, e.g., a loan whose sole
purpose is to generate interest deductions. See id.; Goldstein, 364 F.2d at 740.
The Federal Circuit in Salem ‐‐ again analyzing a STARS transaction
under a bifurcated analysis ‐‐ held that, unlike Lee and Goldstein, ʺthere is no
evidence that [the taxpayer bank] designed the Loan solely to claim the interest
deductions.ʺ 786 F.3d at 957. ʺWhile it may be true that the Loan operated partly
to camouflage the [tax‐spread] payment, it also resulted in a substantive change
‐ 48 ‐ in [the taxpayer bankʹs] economic position. As a result of the Loan transaction,
[the taxpayer bank] obtained unrestricted access to $1.5 billion in loan proceeds.ʺ
Id.
2. Application
The Commissioner contends that BNYʹs loan lacked economic
substance because it was overpriced and motivated by tax avoidance, and that
therefore BNY should not be able to deduct associated interest expenses. See
Kerman v. Commʹr, 713 F.3d 849, 865 (6th Cir. 2013) (concluding that loan
transaction lacked economic substance, in part because of its ʺabsurdly high
interest rateʺ (internal quotation marks omitted)). We agree with the Tax Court
that the $1.5 billion loan from Barclays had independent economic substance.
Thus, BNY was entitled to deduct the interest expenses it paid on this loan.
First, as discussed above, the Tax Court correctly bifurcated the
STARS trust transaction from the $1.5 billion loan.
Second, we conclude that the $1.5 billion loan had independent
economic substance. In Lee and Goldstein, we held that interest expenses were
not deductible because the relevant loan arrangements could ʺnot with reason be
said to have purpose, substance, or utility apart from their anticipated tax
‐ 49 ‐ consequences.ʺ Goldstein, 364 F.2d at 740; see Lee, 155 F.3d at 586‐87. As the Tax
Court observed, however, BNY ʺdid not use the loan proceeds to finance, secure
or carry out the STARS structure. The loan was not necessary for the STARS
structure to produce the disallowed foreign tax credits. Rather, the loan
proceeds were available for petitioner to use in its banking business throughout
the STARS transaction.ʺ Bank of N.Y. Mellon Corp. v. Commʹr, 106 T.C.M. (CCH)
367 (T.C. 2013). Under both the objective and subjective prongs of the economic
substance doctrine, the loan was no sham: It constituted $1.5 billion in cash that
was available for BNY to utilize in any way it saw fit throughout the duration of
STARS.
The Commissioner argues that because the loan was ʺoverpricedʺ ‐‐
as BNY could have obtained a similar loan at a lower cost in the marketplace ‐‐
we should still disallow the interest expense deductions. We have held,
however, that ʺ[e]ven if the motive for a transaction is to avoid taxes, interest
incurred therein may still be deductible if it relates to economically substantive
indebtedness.ʺ Lee, 155 F.3d at 586 (quoting Jacobson, 915 F.2d at 840) (internal
quotation marks omitted). Again, here, the $1.5 billion loan was economically
‐ 50 ‐ substantive. We thus decline to disallow the deductions on the theory that
BNYʹs loan lacked economic substance because it was overpriced.
Accordingly, we conclude that the Tax Court did not err, on
reconsideration, in allowing BNY to deduct interest expenses on the $1.5 billion
loan.
CONCLUSION
Accordingly, the decisions of the district court and Tax Court are
AFFIRMED. To summarize:
(1) We reject AIGʹs contention that foreign tax credits, by their
nature, are not reviewable for economic substance. The purpose of the
ʺeconomic substanceʺ doctrine is to ensure that a taxpayerʹs use of a tax benefit
complies with Congressʹs purpose in creating that benefit. Accordingly, we hold
that the ʺeconomic substanceʺ doctrine can be applied to disallow a claim for
foreign tax credits.
(2) In determining whether a transaction lacks economic
substance, we consider: (a) whether the taxpayer had an objectively reasonable
expectation of profit, apart from tax benefits, from the transaction; and (b)
whether the taxpayer had a subjective non‐tax business purpose in entering the
‐ 51 ‐ transaction. Gilman, 933 F.2d at 147‐48. In our Circuit, we employ a ʺflexibleʺ
analysis where both prongs are factors to consider in the overall inquiry into a
transaction’s economic substance.
(3) The focus of the objective inquiry is whether the transaction
ʺoffers a reasonable opportunity for economic profit, that is, profit exclusive of
tax benefits.ʺ Gilman, 933 F.2d at 146 (internal quotation marks omitted). We
conclude, as a matter of first impression in this Circuit, that foreign taxes are
economic costs and should thus be deducted when calculating pre‐tax profit. We
also conclude that it is appropriate, in calculating pre‐tax profit, for a court both
to include the foreign taxes paid and to exclude the foreign tax credits claimed.
In so holding, we agree with the Federal Circuit in Salem and disagree with
decisions of the Fifth and Eighth Circuits (Compaq and IES, respectively).
(4) Under the subjective prong, a court asks whether the taxpayer
has a legitimate, non‐tax business purpose for entering into the transaction.
(5) As to AIGʹs transactions, we hold that there are unresolved
material questions of fact regarding the objective factors ‐‐ i.e., the economic
effects of the cross‐border transactions and the reasonableness of AIGʹs
expectation of non‐tax benefits. There are also material questions of fact
‐ 52 ‐ regarding AIGʹs subjective business purpose for entering the cross‐border
transactions. Because a reasonable factfinder could resolve these questions in
favor of the government and conclude therefrom that the cross‐border
transactions lacked economic substance, the district court did not err in denying
AIGʹs motion for partial summary judgment.
(6) As to BNYʹs transactions, we hold that the Tax Court correctly
concluded that the STARS trust transaction lacked economic substance. We also
hold that the Tax Court did not err in concluding that the $1.5 billion loan from
Barclays had independent economic substance, and that BNY was therefore
entitled to deduct the associated interest expenses. Accordingly, we affirm the
Tax Courtʹs judgment in its entirety.
‐ 53 ‐
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Bank of N.Y. Mellon v. Comm'r Am. Int'l Grp., Inc. v. United States, Counsel Stack Legal Research, https://law.counselstack.com/opinion/bank-of-ny-mellon-v-commr-am-intl-grp-inc-v-united-ca2-2015.