First, here is the unofficial summary:
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.Well, that's pretty cryptic. I won't try to summarize the complex facts whereby the parties involved tried to exploit the tax regimes of the countries involved. The Court summarizes its holdings in the Conclusion as follows:
The Court summarizes all of its holdings in the conclusion:
Accordingly, the decisions of the district court and Tax Court are AFFIRMED. To summarize:
(1) We reject AIG's contention that foreign tax credits, by their nature, are not reviewable for economic substance. The purpose of the "economic substance" doctrine is to ensure that a taxpayer's use of a tax benefit complies with Congress's purpose in creating that benefit. Accordingly, we hold that the "economic substance" 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 transaction. Gilman, 933 F.2d at 147-48. In our Circuit, we employ a "flexible" 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 "offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits." 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 AIG's 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 AIG's expectation of non-tax benefits. There are also material questions of fact regarding AIG's 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 AIG's motion for partial summary judgment.
(6) As to BNY's 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 Court's judgment in its entirety.I now want to focus on the economic substance holding related to the the foreign tax credit manipulation that the Fifth Circuit and the Eighth Circuit had blessed in Compaq Comput. Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001); and IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001). Essentially, in calling the tax shelters in the instant cases bullshit, the Court was, in kinder judicial language, calling Compaq and IES bullshit as well. So, let's see how it did that:
a. Objective Economic Substance
The focus of the objective inquiry is whether the transaction "offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits." 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 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 "[o]ur precedent, like that of several other courts, supports the government's approach, i.e., to assess a transaction's economic reality, and in particular its profit potential, independent of the expected tax benefits." 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 "profitless." 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 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. n8 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.
n8 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 government's 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).
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. Comm'r, 277 F.3d 778 (5th Cir. 2001), rev'g, 113 T.C. 214 (1999); IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), rev'g, No. C97-206, 1999 WL 973538 (N.D. Iowa Sept. 22, 1999). In both cases, taxpayers purchased publicly traded foreign securities known as American Depository Receipts ("ADRs") 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 "loss" 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, holding that it erred in ignoring Compaq's 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. "To 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." 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 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 Court's decision in BNY, disagreed with the reasoning in Compaq and IES. The court in Salem concluded that the Tax Court's 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 "economic substance" must be analyzed within the context of the tax implications: "Even 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." 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 to discern, as a matter of law, whether a transaction meaningfully alters a taxpayer's economic position other than with respect to tax consequences. The motivation behind the economic substance inquiry "is to ensure that tax benefits are available only if 'there 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.'" Id. (quoting Frank Lyon, 435 U.S. at 583-84). The doctrine was born out of necessity, as "[e]ven the smartest drafters of legislation and regulation cannot be expected to anticipate every [tax avoidance] device." ASA Investerings P'ship v. Comm'r, 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. Int'l 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 "buying into" the government's "smoke and mirrors" argument or "contorting" the economic substance doctrine "beyond any recognizable bounds." n9 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 "fictionalizes" the transactions, including the costs of the transactions but not the corresponding income.
n9 See Kevin Dolan, The Foreign Tax Credit Diaries -- Litigation Run Amok, 71 Tax Notes Int'l 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 Court's "AIG" 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).
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 "loan" for U.S. tax purposes but as equity for foreign tax purposes solely to minimize tax in both countries. Hence, the transactions themselves "fictionalize" 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 "real" insofar as real money changed hands, they are most appropriately characterized as "shams" 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 taxes are economic costs for purposes of the economic substance doctrine and thus should be deducted from profit before calculating pre-tax profit.In their attempts to smoke this stuff past the Second Circuit, the taxpayers in these cases had some of the best lawyers that money can buy. I list the non-government attorneys in the case:
Counsel: 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.
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.
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, for Amicus Curiae United States Chamber of Commerce.
Martin S. Kaufman, Larchmont, New York, for Amicus Curiae Atlantic Legal Foundation.I haven't read the amicus briefs and the Court does not indicate whose side they were taking (doubt they were neutral, so also doubt that they took the Government's side).
Finally, I ask as I have before about bullshit tax shelters -- called shams here -- are not within the scope of the criminal sanctions of the Code, as well as civil fraud penalties.