Court of Federal Claims Follows Tax Court and Rejects the STARS Transaction
September 2013On September 20, 2013, the U.S. Court of Federal Claims issued an opinion in favor of the government in the case of Salem Financial, Inc. v. United States. The case involved a cross-border tax-advantaged financing transaction, known as STARS, which was co-marketed to Salem Financial by Barclays Bank PLC and the U.S. accounting firm KPMG LLP. In Bank of New York Mellon Corporation v. Commissioner of Internal Revenue the Tax Court considered the STARS transaction and denied the taxpayer the purported tax benefit (foreign tax credits) on grounds that the transaction, while compliant with the statute, failed to satisfy the economic substance doctrine. The case is of interest because it illustrates the expanding scope of the economic substance doctrine and the enhanced role of the courts in making U.S. federal income tax law.
In an earlier post, we described in detail the STARS transaction when discussing the Bank of New York opinion. To summarize, the transaction involved a U.K. tax resident trust (the “STARS Trust”) and a loan by Barclays to a subsidiary of Salem Financial (the “taxpayer”). The STARS Trust was funded primarily with assets provided by the taxpayer, and the income from these assets was taxed in the United Kingdom. Barclays claimed a credit for these taxes in the United Kingdom, and the taxpayer claimed a credit for them in the United States. Barclays also lent funds to the taxpayer and rebated a portion of its U.K. tax saving to the taxpayer. The taxpayer argued that it had entered into the STARS transaction to achieve a low after-tax cost of funding.
The court's analysis in Salem Financial is similar to the Tax Court's analysis in Bank of New York. The court accepted the government's argument that the STARS Trust generating foreign tax credits and Barclays’ loan to the taxpayer were "economically distinct" and should not be viewed as an integrated transaction.
Although the taxpayer technically was entitled to a credit for the U.K. taxes paid by the STARS Trust, like several other courts, the Court of Federal Claims found that Congress intended that a credit for foreign taxes paid or accrued be allowed only when a taxpayer engages in “purposive activity” or the transaction generating the taxes has “economic utility.” After a lengthy analysis focused on circular cash flows through the STARS Trust and examination of the possibility of profit, the court concluded that “the STARS Trust must be disregarded as a sham structure. Under both economic substance and substance-over-form doctrine, the creation and use of sham structures to achieve tax benefits are disregarded for federal tax purposes.”
The court also found that the loan from Barclays to the taxpayer "lacked economic substance because it was not structured to make a profit, but instead was devised to provide . . . a pretext for a purported business purpose for engaging in a sham transaction.” The court therefore denied the taxpayer a credit for the U.K. taxes paid on the STARS transaction.
In contrast to the Tax Court in Bank of New York, which did not consider whether the taxpayer owed penalties as a result of entering into the STARS transaction, the court in Salem Financial considered whether the taxpayer was liable for the negligence penalty and the substantial understatement of income tax penalty. The court found the taxpayer liable for both.
The court’s reasoning as to why the negligence penalty is due is both significant and surprising. In finding the taxpayer liable for the negligence penalty, the court had to consider whether the taxpayer had a reasonable basis for the position taken. Ordinarily, the taxpayer may avoid the negligence penalty if it relied on a reasoned opinion of a tax advisor. In order to prevail, the taxpayer must show that the tax advice proffered was reasonable and it was reasonable for the taxpayer to rely on the advice.
The taxpayer was provided tax opinions by both KPMG and the law firm of Sidley Austin. The court found both tax opinions to be unreasonable. KPMG’s opinion was based on “unreasonable and unsupported assumptions” according to the court. The court also found the Sidley Austin opinion to be "largely pre-fabricated and predetermined." The court also rejected the opinion because it was "premised on the unreasonable and unsupported assumption that technical compliance with U.S. tax law would allow the IRS to give its imprimatur to an economically meaningless transaction."
The court also found that the taxpayer unreasonably relied on the opinions of KPMG and Sidley Austin: “Because both KPMG and Sidley Austin had a significant interest in convincing [the taxpayer] to engage in the STARS transaction, the court cannot say that [the taxpayer] acted reasonably in relying on their advice.”
Finally, the court criticized the taxpayer’s employees and the various advisors involved with STARS:
The conduct of those persons from [the taxpayer], Barclays, KPMG, and the Sidley Austin law firm who were involved in this and other transactions was nothing short of reprehensible. . . . [T]he professionals involved should have known better than to follow the STARS path, rife with its conflicts of interest, questionable pro forma legal and accounting opinions, and a taxpayer with a seemingly insatiable appetite for tax avoidance.
This decision illustrates the expanding power of the federal judiciary to effectively make federal income tax law by invoking the economic substance doctrine to overturn a transaction that, albeit aggressive, otherwise complies with the letter of the law. This is a power that could not be fully anticipated when the STARS transaction was devised and implemented approximately 10 years ago. Even today the boundaries of the economic substance doctrine are imprecise. It is often difficult to predict whether a court will rely on the doctrine to recast a transaction that otherwise complies with the statute and regulations in order to deny tax benefits. Complex structured financings and partnership transactions with either a tax-neutral party or a related party involving a large tax saving are often vulnerable.
This case is likely to be appealed because of the amount of tax ($770 million) and penalties ($112 million) at stake, as well as the subjective nature of the economic substance doctrine. Taxpayers and the government will have certainty only after the appellate courts have stated their views on STARS. Whether the appellate courts will agree that Congress intended to allow the foreign tax credit only when a taxpayer engages in “purposive activity” is not clear. In order to appeal successfully, the taxpayer may therefore need to convince a court to view the STARS Trust and the bank loan as a single transaction with a strong business motive. The opinion of the Court of Federal Claim, however, creates a lengthy record that casts the taxpayer in a relatively poor light.
 No. 10-192T (Filed September 20, 2013) (“Salem Financial”). Bank of New York Mellon Corporation v. Commissioner, U.S. Tax Court, Docket No. 26683-09, Decided February 11, 2013 (“Bank of New York”).
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