Federal Circuit Affirms That STARS Trust Lacks Economic Substance
On May 14, 2015, the U.S. Court of Appeals for the Federal Circuit issued its opinion in Salem Financial, Inc. v. United States. The Court of Appeals affirmed the decision of the Court of Federal Claims that the STARS trust lacked economic substance and so denied the taxpayer foreign tax credits flowing through the trust, but reversed the lower court in finding that the taxpayer was entitled to a deduction for interest accrued on a related loan. The Court of Appeals also affirmed the decision of the lower court that the taxpayer was liable for interest and penalties. The case is of interest because it illustrates the expanding (and uncertain) scope of the economic substance doctrine and the enhanced role of the courts in making U.S. federal income tax law.
Overview of the STARS transaction
The STARS transaction is a cross-border, tax-advantaged financing transaction that was co-marketed by Barclays Bank and the accounting firm KPMG LLP. It was implemented by several U.S. banks prior to 2007. The transaction has two components: a trust, which owns assets that produce income subject to U.K. tax, and a loan by Barclays to the U.S. taxpayer. The opinion of the Federal Circuit focuses primarily on the trust.
In 2002, Salem Financial, Inc. (the “taxpayer”) created the trust and contributed approximately $5.8 billion of income producing assets to it. The trust had a U.K. trustee which caused it to be subject to U.K. tax. As part of the transaction, the trust would temporarily place distributions of income into the “Barclays Blocked Account.” Thereafter, those funds were returned to the trust and distributed to the taxpayer.
Under U.K. tax law, Barclays was entitled to a credit for a portion of the U.K. taxes paid by the trust and to a trading loss that was created as a result of the flow of cash into and out of the Barclays Blocked Account. Also, as part of the transaction, Barclays made a monthly payment to the taxpayer (the “Bx payment”) equal to 51 percent of the U.K. taxes paid by the trust.
The court found “the net benefit to Barclays, for every $100 of trust income, was . . . $7.70, based on U.K. tax credits and deductions . . .” The court also found that the taxpayer, for every $100 of trust income, “having paid $22 U.K. tax on the trust income, would claim a foreign tax credit of $22 for the entire amount of the trust’s U.K. taxes. However, having received the $11 Bx payment from Barclays, [the taxpayer] would have a net gain of $11.” Thus, both Barclays and the taxpayer benefited from the transaction. The circuit court referred to the trust as a “money machine.”
The STARS trust lacked economic substance
The economic substance doctrine is the common law doctrine under which certain tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. For purposes of applying the economic substance doctrine, the lower court had considered the trust separately from the loan. The Court of Appeals also considered the trust separately in applying the economic substance doctrine.
The Court of Appeals made several findings in reaching its conclusion that the trust lacked economic substance. First, it concluded that the Bx payments were income to the taxpayer and not a rebate of U.K. taxes as the government argued.. The court also considered whether the trust’s U.K. taxes should be treated as an item of expense (or ignored) in evaluating economic substance. The court stated:
“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 the 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 provisions.”
The court also said,
“[W]e disagree with the government that a transaction that fails the profit test [when foreign taxes are treated as an expense] must necessarily be deemed a sham. Nonetheless, if a taxpayer incurred a large foreign tax expense that would render the transaction unprofitable absent the foreign tax credit, that situation demands careful review of the transaction.”
Finally, the circuit court concluded:
“As the trial court found, the trust transaction reflected no meaningful economic activity by [the taxpayer]: the incremental profit potential of the trust (beyond the income already generated by the underlying assets) depended entirely on Barclays’ and [the taxpayer’s] anticipated tax benefits; exposed [the taxpayer] to no economic risk . . . and had no realistic prospect of producing a profit (apart from the fact of the foreign tax credit).”
The STARS trust lacked business purpose
The circuit court also considered the second part of the economic substance doctrine: whether the trust had a bona fide business purpose. The court rejected the taxpayer’s argument that it sought to earn a profit from the Bx payments. The court found those payments to be simply a means of sharing a tax benefit and not evidence of business purpose. The court also rejected the taxpayer’s argument that the trust was established in order to allow Barclays to claim U.K. tax benefits and that demonstrated a business purpose.
The court concluded:
“Although [the taxpayer] receives income in the form of the Bx payment, the transaction that generated that income involves no genuine business activities, and the transaction that produced the Bx payment would not have been engaged in but for the system of taxes imposed by the U.S. and U.K. governments. [Citation omitted]. Congress could not have intended to allow a taxpayer to claim a foreign tax credit, at the expense of U.S. tax revenue, for a transaction involving no commerce or bona fide business abroad and having no purpose other than to obtain foreign and domestic tax benefits.”
As the court observed in its opinion, under the Internal Revenue Code and regulations, the U.K. income taxes paid by the trust were creditable by the taxpayer. The U.S. foreign tax credit rules are quite detailed, so this case demonstrates that the economic substance doctrine may reverse the tax consequences of even complex and thorough provisions of the tax law.
Other U.S. banks entered into the STARS transaction and are contesting the government’s disallowance of their tax benefits under the economic substance doctrine. If the circuit courts split on this issue, then the Supreme Court might decide to review the STARS transaction. Should that come to pass, perhaps the Court could provide some clarity as to the boundaries of the economic substance doctrine. For now, tax planners and their clients should do their best to steer clear of the shoals presented by the doctrine.
 2015 BL 148218 (May 14, 2015) (“Salem Financial”). The taxpayers a subsidiary of the Branch Banking & Trust Corporation. In connection with the transaction, the taxpayer claimed foreign tax credits of $498 million. Congress codified economic substance doctrine in 2010. Section 7701(o). The proper treatment of foreign income taxes in applying the economic substance doctrine was considered in Compaq Computer v. Commissioner, 277 F.3d 778 (5th Cir. 2001), rev’g 113 TC 114 (1991) and has been widely discussed in the tax literature. See, e.g., Shaviro and Weisbach, The Fifth Circuit Gets It Wrong in Compaq v. Commissioner, Tax Notes, January 28, 2002. Unlike the Federal Circuit, another court might view the trust and the loan as a unit when applying the economic substance doctrine. The STARS transaction offered a below market interest rate because of the U.K. tax benefits claim by Barclays. Another court therefore might conclude that the transaction had a satisfactory business purpose and find for the taxpayer.KEYWORD: Economic Substance Doctrine
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