Yet Another Bullshit Tax Shelter Goes Down; BB&T's Streak on Bullshit Tax Shelters Continues (9/21/13)

In Salem Financial, Inc. v. United States, 112 Fed. Cl. 543, 2013 U.S. Claims LEXIS 1372 (9/20/13), here, the court (Judge Wheeler) rejects yet another bullshit tax shelter wrapped in complexity but no substance.  This one's acronym is STARS ("Structured Trust Advantaged Repackaged Securities") "The acronym "STARS" 

is not particularly descriptive of the transaction at issue. There is no indication of a loan in the acronym and there are no "repackaged securities" in the transaction. The evidence suggests that the concept of STARS began as something different, and only grew to include a loan when marketed to banks in the United States..  

The beginning of the opinion sets the tone (bold face supplied by JAT):

The BB&T STARS transaction was in effect for nearly five years, from August 1, 2002 through April 5, 2007. The purpose of the STARS transaction was to generate large-scale foreign tax credits for a U.S. taxpayer, which could be used to enhance revenue and reduce taxes in the United States. The amount at issue in this case, including the potential assessment of taxpayer penalties, is $772,144,153.45. This amount is comprised of the following: disallowed foreign tax credits ($498,161,951); disallowed interest deductions ($74,551,947.40); the tax paid on "Bx" payments from Barclays to BB&T ($84,033,228.20); disallowed transaction cost deductions ($2,630,125.05); and penalties ($112,766,901.80). 

The complexities of the STARS transaction, including the concept of a Bx payment, will become apparent below. Stripped to its essence, however, STARS called for the U.S. taxpayer, in this case BB&T, to establish a trust containing approximately $6 billion in revenue-producing bank assets. The monthly revenue from the trust was then cycled through a U.K. trustee, an act that served as a basis for U.K. taxation. Although the revenue was immediately returned to BB&T's trust, the assessment of U.K. taxes generated U.K. tax credits that were shared 50/50 between Barclays and BB&T. A $1.5 billion loan from Barclays to BB&T also was part of the structured transaction, although the loan was not necessary to the objective of generating foreign tax credits. The Barclays monthly Bx payment to BB&T represented BB&T's share of the tax credits, and had the effect of reducing the interest cost of BB&T's loan. The main question presented is whether the STARS transaction had any purpose other than to generate tax savings, and if not, whether penalties should be assessed against BB&T.
The parties provided a STARS tax tutorial presentation to the Court on February 13, 2013 before the trial began. The Court held 21 days of trial in Washington, D.C. from March 4 through April 2, 2013. During the trial, the Court heard the testimony of 26 witnesses, of which thirteen were experts. The Court admitted deposition excerpts for eleven additional witnesses, principally from those persons who reside outside the United States or where the parties agreed that a deposition could substitute for relatively brief testimony. The Court received in evidence approximately 1,250 exhibits during the trial. The parties submitted post-trial findings of fact and memoranda of law on June 7, 2013, and post-trial reply briefs on July 3, 2013. The Court heard closing arguments on July 30, 2013.

There are different ways of looking at the BB&T STARS transaction, and the Court has wrestled with the question of how best to analyze its various components. The STARS trust component, where BB&T revenue momentarily is cycled through a U.K. trustee to create U.K. taxes and foreign tax credits, and then is returned to BB&T, quite clearly is an abusive tax avoidance scheme. The trust creates a series of instantaneous circular cash flows starting and ending with BB&T where no economic activity has occurred abroad to justify the assessment of a U.K. tax. While inarguably sophisticated and creative, the trust purely and simply is a sham transaction accomplishing nothing more than a redirection of cash flows that should have gone to the U.S. Treasury, but instead are shared among BB&T, Barclays, and the U.K. Treasury. The Court finds that the trust component of STARS lacks economic substance. 

However, the Court must consider whether the existence of Barclays' $1.5 billion loan to BB&T at favorable interest rates somehow provides the necessary economic substance to salvage the STARS transaction. In analyzing this question, the Court notes that the loan interest rate actually is higher than normal for BB&T until the Barclays' rebate of U.K. taxes through the Bx payment comes into play. The Barclays' Bx payment each month from the sham trust transaction creates the unusually attractive interest rates. Without the Bx payments, the Court is persuaded that BB&T would not have entered into the STARS transaction. The loan transaction thus is substantially influenced by the payments from the sham trust. The loan lacks economic reality where the interest rate is so low that for nearly the first three years of the transaction, Barclays, the lender, makes Bx payments to BB&T, the borrower, exceeding by millions the interest payments due from BB&T to Barclays. An arrangement where a lender makes payments to a borrower for the first three years of a loan surely would raise the eyebrows of even an experienced financier. 

Regardless of whether the Court views the trust and the loan separately or together as one integrated STARS transaction, the Court concludes that the entire arrangement must be disregarded for lack of economic substance. Among the most telling evidence at trial was the revelation that the amount of the loan was unrelated to the amount of the Bx payments. That is, in the relevant formulas created for the STARS transaction, a change in the loan amount does not have any effect on the Bx payment amount. Thus, rather than being intricately linked together with the trust, the loan serves only to add a hoped-for business purpose to the tax avoidance scheme. The Court cannot find economic substance in a loan transaction that is so heavily driven by Bx payments from the sham trust. 

For reasons that will be explained, the Court also finds that BB&T is liable for tax penalties for its participation in the STARS transaction. The conduct of those persons from BB&T, Barclays, KPMG, and the Sidley Austin law firm who were involved in this and other transactions was nothing short of reprehensible. Perhaps the business environment at the time was "everyone else is doing it, why don't we?" Perhaps some of those who participated simply were following direction from others. Nevertheless, the 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. One of Defendant's experts, Dr. Michael Cragg, aptly stated that "enormous ingenuity was focused on reducing U.S. tax revenues." Cragg, Tr. 4687. After wading through the intricacies of the STARS transaction, the Court shares Dr. Cragg's view that "[t]he human effort, the amount of creativity and overall effort that was put into this transaction . . . is a waste of human potential." Id.

I have been observing the tax shelter scene for some time now and have written on it frequently in this blog.  It is amazing to me how the usual suspects are encountered over and over.  Those familiar with this scene will recognize the following litany of names (not all, but just some that grabbed my attention):

BB&T itself  (See the section of the opinion titled "B. BB&T's Participation in Other Tax Shelters" 

Barclays PLC 

KPMG LLP 

Sidley Austin Brown & Wood LLP (and a predecessor by merger, Brown & Wood, Ruble's prior firm) 

PricewaterhouseCoopers LLP (a player in the tax shelter field but a less visible one, serving the role of independent accountants in this case; PwC's opinion ultimately was less than "should," but that did not dissuade BB&T; a less than "should" opinion covers a lot of potential ground -- all the way to frivolous and criminal -- but was probably couched this way to infer but not state that perhaps it was more likely than not when, of course, it was frivolous or less; note the Court's holding below that the position did not even have substantial authority). 

R. J. Ruble, a partner at Sidley Austin, previously convicted and jailed for his BLIPS tax shelter activity 

David Brockaway, head of KPMG WNT "heavily involved in the development of the STARS concept, and in drafting STARS tax opinions and promotional materials."

Other snippets that I found interesting:

In August 2005, the United States indicted Mr. Ruble and charged him with tax evasion for "designing, implementing, and marketing fraudulent tax shelters." United States v. Pfaff, 619 F.3d 172, 173 (2d Cir. 2010). On December 17, 2008, a jury found Mr. Ruble guilty on ten counts of attempting to evade or defeat U.S. tax laws, and he was sentenced to 78 months of incarceration and two years of supervised release. He currently is incarcerated in the United States penitentiary in Lewisburg, Pennsylvania. Defendant deposed Mr. Ruble in this case, but in response to every question after providing his name, Mr. Ruble asserted his Fifth Amendment right not to answer. Mr. Ruble did not testify at trial. The STARS transactions were not among the tax shelters at issue in Mr. Ruble's criminal proceedings. 

Prior to the start of trial, Plaintiff filed a motion in limine to preclude Defendant from seeking adverse inferences against Plaintiff due to Mr. Ruble's assertion of the Fifth Amendment in response to all questions. Later, after trial, Plaintiff filed a motion to reopen the trial record to obtain Mr. Ruble's substantive testimony in response to written questions previously posed to him in his deposition. On June 13, 2013, the Court issued an order regarding the testimony of Raymond J. Ruble, denying Plaintiff's motion to reopen the trial record, but granting Plaintiff's motion to preclude the application of an adverse inference from Mr. Ruble's assertion of his Fifth Amendment rights. The Court reasoned that Mr. Ruble most likely had asserted the Fifth Amendment for personal reasons, not because of a desire to protect Plaintiff or influence the outcome of this case. See Order, June 13, 2013, Dkt. No. 213. 

* * * * 

H. Costs and Fees of BB&T STARS

1. Third Party Fees 

As discussed above, KPMG and BB&T negotiated and agreed to a fixed fee of $6.5 million, plus hourly assistance. JX 254. Of that amount, $500,000 would be deferred for each of the five projected years of STARS. Monger, Tr. 1196; JX 254. Mr. Monger also negotiated with KMPG that it would render a minimum amount of services for no fee in the event of an IRS audit of the STARS transaction, not to exceed 350 hours. USX 470; Monger, Tr. 1156-1157; Watson, Tr. 3471-73, 3622-25; JX 254. Fees for examination assistance in excess of 350 hours were to be billed at mutually agreeable rates. JX 264. The $6.5 million in fees was "by a significant margin" the most that BB&T had ever paid for a "tax solution." Monger, Tr. 1191; USX 2238 at 1-2. 

Also as discussed above, BB&T retained the law firm of Sidley Austin to assist in tax matters. Monger, Tr. 1295; JX 243. Sidley Austin was to receive a flat fee of $300,000 for tax matters, and monthly billing at the firm's standard rate for any corporate law work. JX 243 at ¶ 3. BB&T paid a total of $1,355,929.91 to Sidley Austin for its various legal opinions and other advice provided with the transaction. USX 679 at 1, 4; USX 937 at 1-3; USX 1115; USX 1587; USX 1966; USX 2096. The total fees that BB&T paid to KPMG and Sidley Austin represented "52 or 53 basis points" on the $1.5 billion financing. Monger, Tr. 699.
BB&T incurred fees for services rendered by PwC with respect to the STARS transaction from March 16, 2002 through May 15, 2003. BB&T paid PwC a total amount of $117,085. USX 591. 

BB&T did not pay Barclays a direct fee for its participation in the transaction. LaRue, Tr. 5322. 

* * * * 

C. Economic Substance of STARS

As noted above, a taxpayer bears the burden of proving that the challenged transaction had (1) objective economic substance and (2) a non-tax business purpose. Wells Fargo, 91 Fed. Cl. at 81 (citing, inter alia, Coltec, 454 F.3d at 1355-56). The objective inquiry focuses on whether the transaction created a reasonable opportunity of making a profit from the transaction. Coltec, 454 F.3d at 1356; Bank of New York, 140 T.C. at34. The subjective, non-tax business purpose inquiry focuses on whether "the taxpayer's sole subjective motivation is tax avoidance," including whether the transaction is "shaped solely by tax-avoidance features." Coltec, 454 F.3d at 1355, 1355 n.13 (quoting Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978)). The transaction to be analyzed is the one that gave rise to the alleged tax benefit, id. at 1356, "even if it is part of a larger set of transactions or steps," Bank of New York, 140 T.C. at 33 (citing, inter alia, Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir. 2002). "Stated another way, the requirements of the economic substance doctrine are not avoided simply by coupling a routine transaction with a transaction lacking economic substance. A contrary application would undermine the flexibility and efficacy of the economic substance doctrine." Id. (citation omitted); see also Coltec, 454 F.3d at 1356 (observing that a taxpayer cannot show a non-tax business purpose "simply by showing some factual connection . . . to an otherwise legitimate transaction") (quoting Basic Inc. v. United States, 212 Ct. Cl. 399, 409, 549 F.2d 740 (1977)). 

The first step in the economic substance inquiry is to identify the transaction to be analyzed. The Government urges that the Trust and the Loan are economically distinct, and that as a matter of both law and economics, the Court should conduct an analysis of the Trust as a stand-alone transaction. Plaintiff opposes this view, arguing that STARS "must be analyzed as a single, integrated transaction because the so called 'components' . . . were linked by the business and commercial realities of the parties[.]" Pl.'s Br. 217. The Court agrees with the Government that the links between the Trust and Loan components of STARS are artificial, and further, that the disputed foreign tax credits are attributable solely to the Trust. Accordingly, the Court will bifurcate the STARS transaction and examine the Trust structure for economic substance, independent of the Loan. However, the Court also will apply the economic substance analysis through the lens of STARS as an integrated transaction. As demonstrated below, the STARS transaction also lacks economic substance when the Trust and the Loan are examined together.

I won't get into the details further.  Readers surely get the point and can savor in the details of the opinion if they wish..

I turn now to the penalties -- 20% of the tax due (both tax and penalties draw interest from the original due dates of the returns) on either of two bases -- negligence or substantial understatement.

Discussion of the Negligence Penalty in Section 6662(a), (b) and (c), here:

BB&T's engagement with PwC is insufficient to remove the taint of unreasonableness from the professional tax advice relied upon. PwC's involvement in the STARS transaction does not create a reasonable basis for BB&T's tax position because: (1) BB&T reported only Barclays, KPMG, and Sidley Austin as its tax advisors to the STARS transaction, JX 234; (2) PwC explicitly informed BB&T that it "in no way [was] providing an Opinion" regarding STARS, JX 259; and (3) PwC's audit advice was informed by the unreasonable and unsupported representations made by KPMG and Sidley Austin, Boss, Tr. 2042-46; USX 568; JX 859. Moreover, PwC ultimately arrived at a "less than should" level of comfort that the IRS would accept the STARS transaction. Boss, Tr. 2098, 2117-18; USX 951A at 7183-84; USX 553, 601, 611. During exceptional cross-examination by Defendant's counsel, PwC's Mr. Boss was evasive and had few answers for the glaring weaknesses that PwC should have seen in the STARS transaction. Boss, Tr. 2131-41. 

Additionally, the BB&T executives that reviewed the economic and tax effects of the STARS transaction are highly educated and well-versed in banking transactions and financing deals. These individuals knew or should have known that claiming nearly $500 million in foreign tax credits by subjecting income to economically meaningless activities was "too good to be true." Indeed, the evidence shows that BB&T executives were extremely skeptical of the tax benefits of STARS, as the potential downside tax risks were the subject of much correspondence and presentation. Monger, Tr. 1102-04, 1126-37; Watson, Tr. 3466-69. Moreover, Mr. Monger generated many spreadsheet analyses calculating BB&T's potential economic return on STARS in the event that the IRS disallowed the foreign tax credits. USX 437. 

BB&T's concern over the tax risk was significantly reflected in the negotiations and eventual fee arrangement with KPMG. In a meeting with KPMG, BB&T representatives expressed a "concern[ ] that KPMG needs to have some of the fee at risk[ ]" and a desire to "reduce [BB&T's] exposure in the event of an early termination of the transaction." Monger, Tr. 1156-57; USX 470. BB&T negotiated that KPMG would provide audit assistance if the IRS challenged the transaction. JX 254. This skepticism on the part of BB&T was well-founded, because as a successful financial holding company with banking subsidiaries in over twelve states, JX 209, it surely would have recognized that the ability to claim nearly $500 million in foreign tax credits merely by subjecting its assets to U.K. taxation was too good to be true. See Neonatology, 299 F.3d at 234 ("When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril."). 

Thus, the fact that BB&T relied on the advice of promoters of the STARS tax shelter despite having ample capacity to recognize that the transaction was "too good to be true," thoroughly vitiates any reasonable basis for BB&T's tax position. Accordingly, Plaintiff is liable for the 20 percent negligence penalty, unless it can establish reasonable cause and good faith, a defense addressed below.

Discussion of the Substantial Understatement Penalty in Section 6662(a), (b) & (d)

To avoid the penalty in the case of a corporate tax shelter, the taxpayer must establish (1) that there was substantial authority for the tax treatment and (2) that the taxpayer reasonably believed that the reported treatment of an item was more likely than not the proper treatment. Treas. Reg. § 1.6662-4(g)(1); see also § 6662(d)(2)(C)(i); Alpha I, 93 Fed. Cl. at 321.16 The substantial authority standard is an objective standard,which is met only if the "weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting contrary treatment." Treas. Reg. § 1.6662-4(d)(3)(i). The weight given to each authority depends on its relevance, persuasiveness, and source. Id. § 1.6662-4(d)(3)(ii). "Conclusions reached in treaties, legal periodicals, legal opinions, or opinions rendered by tax professionals are not authority." Id. at § 1.6662-4(d)(3)(iii); Alpha I, 93 Fed. Cl. at 322 ("Reliance on advice by tax professionals is specifically excluded in deciding whether substantial authority exists for a particular tax treatment."). When a transaction is found to lack economic substance, no authority, much less substantial authority, supports the claimed tax treatment. Stobie Creek, 82 Fed. Cl. at 706, 706 n.64, (finding that transactions lacked economic substance precluded plaintiffs from establishing existence of substantial authority to support tax treatment). 

As discussed in detail above, the STARS transaction lacked economic reality because it was unsupported by a tax-independent business purpose. Thus, because the transaction's significant purpose was "the avoidance or evasion or Federal income tax," STARS falls within the statutory definition of a "tax shelter." § 6662(d)(2)(C)(iii). Not only was the STARS transaction a tax shelter, but it was also an economically meaningless transaction. The STARS transaction was no more than a circular redirection of cash flows from the U.S. Treasury to BB&T, Barclays, and the U.K. Treasury. The Court's determination that STARS lacked economic substance precludes Plaintiff from establishing the first prong of its defense, as there is no authority, much less substantial, that supports "a subterfuge for generating, monetizing and transferring the value of foreign tax credits. . . ." Bank of New York, 140 T.C. at 31; see Stobie Creek, 82 Fed. Cl. at 706 n.64 ("[N]o substantial authority exists to support recognition of tax results that are premised on transactions with no appreciable business purpose beyond conferring tax benefits."); Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 204-05 (D. Conn. 2004) (holding that taxpayer cannot cite authority to support tax treatment once transaction is deemed to lack economic substance). Because the Court finds that substantial authority does not support the tax treatment claimed by BB&T, the Court need not address whether BB&T reasonably believed that the tax treatment claimed was more likely than not the proper treatment. Plaintiff is liable for the 20 percent substantial understatement penalty. 

On Reasonable Cause and Good Faith

As discussed above, the unsupportable assumptions upon which the promoters' advice was based, the conflicts of interest of the STARS promoters, and the BB&T's executives' high level of knowledge and expertise preclude a finding of reasonable reliance on professional advice. Similarly, the weight of the evidence shows that tax avoidance was singularly and precisely the goal pursued in execution of the STARS transaction. Consequently, the Court finds that BB&T did not act with reasonable cause and good faith with regard to any portion of the underpayment determined. 

For the foregoing reasons, the Court finds that Plaintiff was engaged in an economically meaningless tax shelter, that the negligence accuracy-related penalty of § 6662(b)(1) and the substantial understatement accuracy-related penalty of § 6662(b)(2) apply, and that the defenses of reasonable basis, substantial authority, and reasonable cause and good faith are not available to Plaintiff.

 Judge Wheeler properly and judiciously slugged through the whole morass and rejected BB&T's claims.  But, Vincent LaGuardia Gambini (My Cousin Vinny) would have characterized BB&T's claims more succinctly (as he did in his opening argument responding to the prosecutions opening argument):  "everything that guy just said is bullshit... Thank you."

The DOJ Tax press release is here.