Bank of New York Mellon Loses in Tax Court
February 2013On February 11, 2013, the U.S. Tax Court issued a decision in favor of the government in a case involving a tax-advantaged financing transaction entered into between Barclays Bank, PLC (“Barclays”) and the Bank of New York in 2001. The case is significant because it further elucidates how the Tax Court will apply the evolving economic substance doctrine in order to disallow tax benefits to participants in a transaction that otherwise follows the letter of the statutory law. The case also illustrates the increasing influence of the courts in U.S. tax matters, particularly those transactions that are complex or involve areas of the tax law that are less well developed.
For a number of years, beginning in the 1990s, non-U.S. banks and U.S. financial institutions entered into various types of tax-advantaged financing transactions that exploited differences in U.S. and foreign tax laws in order to allow both parties to reduce their after-tax cost of the transaction. Bank of New York examined a transaction known as STARS, an acronym for Structured Trust Advantaged Repackaged Securities, which was marketed by Barclays in the United States.
The tax benefits of the STARS transaction resulted from differences in U.S. and U.K. tax law that allowed Barclays and the Bank of New York each to claim a credit for U.K. taxes imposed on income generated by a portfolio of securities. In 2008 the U.S. Treasury and the IRS issued regulations intended to prospectively eliminate the U.S. foreign tax credit provided by transactions of this type. Barclays and a number of U.S. financial institutions entered into STARS transactions prior to the effective date of these regulations. These transactions have been challenged by the IRS in the courts. Bank of New York is the first STARS case to go to judgment.
The transaction at issue in Bank of New York was relatively complex, involving the formation of multiple entities, a zero coupon swap, a credit default swap, various security arrangements and an interest strip. However, the key business relationship in the STARS transaction involved a common-law trust formed and funded by the Bank of New York (the “STARS Trust"), which then issued various classes of interests (units) to Bank of New York and Barclays. A subsidiary of the Bank of New York (“InvestCo”) owned the class A and the class B units in the STARS Trust, which it received in exchange for the contribution of various securities to the trust.
In order to create a loan from Barclays to the Bank of New York, Barclays purchased the class C and class D units in the trust. These funds were deposited in a blocked account in Barclays' name. Barclays could not access or control this account. The STARS Trust then redeemed InvestCo’s class B shares with a portion of the funds provided by Barclays’ investment. Also, InvestCo entered into a forward sale agreement with Barclays requiring InvestCo to purchase the class C and class B units from Barclays in November 2006. Bank of New York recorded this transaction on its books as a liability to Barclays.
In order to subject the STARS Trust to U.K. taxation, the initial U.S. trustee was replaced with a U.K. trustee. The U.K. trustee was liable for U.K. tax on the income produced by the trust's assets at a rate of 22%. Under U.K. law, Barclays, as a unit holder in the trust, was treated as receiving annual payments from the trust, which were taxable at a rate of 30%. Under U.K. law, the annual payments were grossed up for the tax paid by the U.K. trustee, and Barclays was allowed a credit for these taxes in computing its U.K. corporate income tax liability.
For U.S. income tax purposes, Bank of New York reported the income from the assets in the STARS Trust on its federal income tax return. Bank of New York also claimed a credit for foreign income taxes paid by the U.K. trustee of the STARS Trust. As discussed below, the interest rate on the loan from Barclays to Bank of New York was determined by taking into account these tax benefits.
The Tax Court's opinion
The Tax Court agreed that the STARS transaction was structured so as to satisfy the requirements in the Internal Revenue Code and the Treasury regulations in order to allow Bank of New York to claim a credit for foreign income taxes paid by the STARS Trust. However, the Tax Court also said that the transaction "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." The Tax Court then analyzed whether, under the economic substance doctrine, Bank of New York should be denied a credit for the foreign income taxes paid with respect to the assets of the STARS Trust. It is this analysis that forms the core of the opinion.
This case arose before the codification of the economic substance doctrine in section 7701(o). Because of variation among the circuit courts as to the elements of the doctrine (which section 7701(o) eliminates prospectively), the Tax Court first determined which version of the doctrine to apply. In this case, an appeal of the Tax Court's decision would lie to the Second Circuit, so the Tax Court applied the version of economic substance doctrine developed in that circuit. In applying the economic substance doctrine, the Second Circuit evaluated both the subjective business purpose of the taxpayer and the objective economic substance of the transaction. In the Second Circuit, a finding of a lack of either economic substance or non-tax business purpose "can be but is not necessarily sufficient" to deny the tax benefit of the transaction.
The Tax Court next made a determination that was critical to its decision: the relevant transaction to be tested under the economic substance doctrine. The Tax Court determined that the relevant transaction was the STARS structure itself, not including the loan by Barclays to Bank of New York. The Tax Court reasoned that it was the STARS structure, rather than the loan, that gave rise to the disputed foreign tax credits.
Focusing only on the STARS structure, the Tax Court concluded that the transaction lacked objective economic substance for several reasons. The STARS structure did not increase the profitability of the STARS assets, and the structure did not provide a reasonable opportunity for economic profit to the trust’s investors. The Tax Court also treated the U.K. income taxes paid by the trustee as a cost for purposes of its economic substance analysis. The Fifth and Eighth Circuits have not treated such taxes as a cost for purposes of the economic substance analysis. The Second Circuit has not yet addressed the question, however.
Each month, the STARS Trust distributed income to Barclays’ blocked account, which then was contributed back to the trust. The court characterized this circular cash flow as having "no non-tax economic effect," and the court considered this to be an indicium of a lack of economic substance. The court also refused to consider the income generated by the STARS assets in its analysis, because that income would have been generated absent the STARS transaction.
The Tax Court then considered whether the transaction had a legitimate non-tax business purpose. Bank of New York had argued that the purpose of the transaction was to obtain low-cost financing from Barclays. The court determined, however, that the STARS structure "lacked any reasonable relationship to the loan." It also rejected the argument that the STARS Trust provided security for the loan by finding that the loan was otherwise adequately secured.
The court also rejected the argument that the loan was low-cost. The stated interest rate on the loan was LIBOR plus 30 basis points less a spread. The spread was equal to one half the present value of the U.K. taxes the STARS Trust was expected to pay on the class C unit’s share of income each month. The Tax Court concluded that the spread was only a "tax effect" and not a "component of loan interest" because it "was unrelated to the time value of money or the attendant risks associated with the loan."
Finally, the Tax Court considered whether Congress intended that a foreign tax credit be provided in this case. The Tax Court concluded:
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 New York has announced that it will appeal the Tax Court's decision. The Tax Court's analysis contains several critical elements that the Second Circuit may not find persuasive, which could lead to a reversal on appeal. The Tax Court analyzed the STARS transaction independent of its loan component. The Tax Court also treated foreign taxes as a cost when evaluating economic substance, a position two other circuits have rejected. Finally, the Tax Court refused to treat the tax-based spread as a component of interest when analyzing the cost of the loan. In a year or two we probably should know the Second Circuit’s view on these key issues and whether Bank of New York will be allowed credit for U.K. taxes paid by the STARS Trust.
 Bank of New York Mellon Corporation, as Successor in Interest to the Bank of New York Company, Inc. v. Commissioner of Internal Revenue, U.S. Tax Court, Docket No. 26683-09, Decided February 11, 2013 (“Bank of New York”). From 1994 until 1996 the author worked for Barclays in the business unit that developed and marketed cross-border tax-advantaged financing transactions. The regulations addressed “structured passive investment arrangements” or “SPIAs.” See Reg. § 1.901-2(e)(5)(iv). The Tax Court also concluded that the STARS transaction lacked economic substance even if the loan and the trust work treated as an integrated transaction.
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