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Economic Substance Doctrine Shouldn't Apply to FTCs, Bank Says

JUN. 12, 2014

Bank of New York Mellon Corp. et al. v. Commissoner

DATED JUN. 12, 2014
DOCUMENT ATTRIBUTES
  • Case Name
    THE BANK OF NEW YORK MELLON CORPORATION, AS SUCCESSOR IN INTEREST TO THE BANK OF NEW YORK COMPANY, INC., Petitioner-Appellant/Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee/Cross-Appellant.
  • Court
    United States Court of Appeals for the Second Circuit
  • Docket
    Nos. 14-704, 14-1394
  • Authors
    Waxman, Seth P.
  • Institutional Authors
    Wilmer Cutler Pickering Hale and Dorr LLP
  • Cross-Reference
    Appealing Bank of New York Mellon Corp. v. Commissioner, 140

    T.C. 15 (2013) 2013 TNT 29-8: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2014-15130
  • Tax Analysts Electronic Citation
    2014 TNT 117-17

Bank of New York Mellon Corp. et al. v. Commissoner

 

UNITED STATES COURT OF APPEALS

 

FOR THE SECOND CIRCUIT

 

 

On Appeal from the United States Tax Court, No. 26683-09

 

(Kroupa, J.)

 

 

BRIEF FOR PETITIONER-APPELLANT/CROSS-APPELLEE

 

 

William J. Perlstein

 

Alan E. Schoenfeld

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

7 World Trade Center

 

250 Greenwich Street

 

New York, Ny 10007

 

(212) 230-8800

 

 

Roger M. Ritt

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

60 State Street

 

Boston, Ma 02109

 

(617) 526-6000

 

 

Seth P. Waxman

 

Catherine M.A. Carroll

 

Weili J. Shaw

 

Jonathan A. Bressler

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

1875 Pennsylvania Avenue, Nw

 

Washington, Dc 20006

 

(202) 663-6000

 

 

June 12, 2014

 

 

CORPORATE DISCLOSURE STATEMENT

 

 

The Bank of New York Mellon Corporation has no parent corporation, and no publicly held corporation owns 10% or more of its stock.

                       TABLE OF CONTENTS

 

 

 CORPORATE DISCLOSURE STATEMENT

 

 

 TABLE OF AUTHORITIES

 

 

 INTRODUCTION

 

 

 JURISDICTIONAL STATEMENT

 

 

 STATEMENT OF ISSUE

 

 

 STATEMENT OF THE CASE

 

 

      A. BNY's Commercial Banking Business

 

 

      B. The STARS Transaction

 

 

           1. Barclays offers BNY an attractive loan

 

 

           2. BNY accepts Barclays's loan

 

 

           3. Barclays makes the loan through the STARS structure

 

 

      C. Taxation Of The STARS Transaction

 

 

           1. BNY's U.K. tax

 

 

           2. Barclays's U.K. tax

 

 

           3. BNY's U.S. tax

 

 

      D. Tax Court Proceedings

 

 

 STANDARD OF REVIEW

 

 

 SUMMARY OF ARGUMENT

 

 

 ARGUMENT

 

 

 I. BNY IS ENTITLED TO FOREIGN TAX CREDITS FOR U.K. TAXES IT PAID ON

 

    THE ECONOMICALLY SUBSTANTIAL STARS TRANSACTION

 

 

      A. Congress Intended The Foreign Tax Credit To Mitigate Double

 

         Taxation

 

 

      B. The Economic-Substance Doctrine Applies In Limited

 

         Circumstances To Disregard Transactions A Taxpayer Undertakes

 

         For No Purpose But Tax Avoidance

 

 

      C. STARS Had Ample Economic Substance For BNY

 

 

 II. THE TAX COURT'S CONTRARY DECISION RESTS ON LEGAL ERRORS

 

 

      A. The Court Erred In Treating Foreign Taxes As A Cost While

 

         Ignoring BNY's Income From The Trust Assets

 

 

      B. The Court Erred In Disregarding BNY's Profit From The Spread

 

 

      C. The Court Erred By Ignoring The $1.5 Billion Loan And The

 

         Return BNY Expected To Earn By Investing The Loan Proceeds

 

 

 CONCLUSION

 

 

 CERTIFICATE OF COMPLIANCE

 

 

                      TABLE OF AUTHORITIES

 

 

                             CASES

 

 

 ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998)

 

 

 Andrew Crispo Gallery, Inc. v. Commissioner, 86 F.3d 42 (2d

 

 Cir. 1996)

 

 

 Biddle v. Commissioner, 302 U.S. 573 (1938)

 

 

 Burnet v. Chicago Portrait Co., 285 U.S. 1 (1932)

 

 

 Coltec Industries, Inc. v. United States, 454 F.3d 1340

 

 (Fed Cir. 2006)

 

 

 Commissioner v. Court Holding Co., 324 U.S. 331 (1945)

 

 

 Commissioner v. National Alfalfa Dehydrating & Milling Co.,

 

 417 U.S. 134 (1974)

 

 

 Commissioner v. Transport Trading & Terminal Corp., 176 F.2d

 

 570 (2d Cir. 1949)

 

 

 Compaq Computer Corp. v. Commissioner, 113 T.C. 214

 

 (1999), rev'd, 277 F.3d 778 (5th Cir. 2001)

 

 

 Compaq Computer Corp. v. Commissioner, 277 F.3d 778

 

 (5th Cir. 2001)

 

 

 Cottage Savings Ass'n v. Commissioner, 499 U.S. 554

 

 (1991)

 

 

 Dow Chemical Co. v. United States, 435 F.3d 594 (6th Cir.

 

 2006)

 

 

 Estate of Stewart v. Commissioner, 617 F.3d 148 (2d Cir. 2010)

 

 

 Frank Lyon Co. v. United States, 435 U.S. 561

 

 (1978)

 

 

 Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67

 

 (2012)

 

 

 Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957)

 

 

 Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991)

 

 

 Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966)

 

 

 Greene v. United States, 13 F.3d 577 (2d Cir. 1994)

 

 

 Gregory v. Helvering, 293 U.S. 465 (1935)

 

 

 Grunebaum v. Commissioner, 420 F.2d 332

 

 (2d Cir. 1970)

 

 

 Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934),

 

 aff'd, 293 U.S. 465 (1935)

 

 

 Hewlett-Packard Co. v. Commissioner, T.C. Memo

 

 2012-135

 

 

 Hines v. United States, 912 F.2d 736 (4th Cir. 1990)

 

 

 IES Industries, Inc. v. United States, 1999 WL 973538 (N.D.

 

 Iowa Sept. 22, 1999), rev'd, 253 F.3d 350 (8th Cir. 2001)

 

 

 IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir.

 

 2001)

 

 

 In re CM Holdings, Inc., 301 F.3d 96 (3d Cir. 2002)

 

 

 Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990)

 

 

 Knetsch v. United States, 364 U.S. 361 (1960)

 

 

 Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956).

 

 

 Lippe v. Bairnco Corp., 288 B.R. 678 (S.D.N.Y. 2003),

 

 aff'd, 99 F. App'x 274 (2d Cir. 2004)

 

 

 Long Term Capital Holdings v. United States, 330 F. Supp. 2d

 

 122 (D. Conn. 2004), aff'd, 150 F. App'x 40 (2d Cir. 2005)

 

 

 Nassau Lens Co. v. Commissioner, 308 F.2d 39 (2d Cir. 1962)

 

 

 Newman v. Commissioner, 902 F.2d 159 (2d Cir. 1990)

 

 

 Nicole Rose Corp. v. Commissioner, 320 F.3d 282

 

 (2d Cir. 2003)

 

 

 Northern Indiana Public Service Co. v. Commissioner, 115 F.3d

 

 506 (7th Cir. 1997)

 

 

 Old Colony Trust Co. v. Commissioner, 279 U.S. 716

 

 (1929)

 

 

 PPL Corp. v. Commissioner, 133 S. Ct. 1897 (2013)

 

 

 Pritired 1, LLC v. United States, 816 F. Supp. 2d 693 (S.D.

 

 Iowa 2011)

 

 

 Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995)

 

 

 Sala v. United States, 613 F.3d 1249 (10th Cir. 2010)

 

 

 Salem Financial, Inc. v. United States, 112 Fed. Cl. 543

 

 (2013), appeal docketed, No. 14-5027 (Fed. Cir.

 

 Dec. 12, 2013)

 

 

 Santander Holdings USA, Inc. v. United States, 977 F. Supp. 2d

 

 46 (D. Mass. Oct. 17, 2013)

 

 

 Scheidelman v. Commissioner, 682 F.3d 189 (2d Cir.

 

 2012)

 

 

 Shell Petroleum, Inc. v. United States, 2008 WL 2714252

 

 (S.D. Tex. July 3, 2008)

 

 

 Shirar v. Commissioner, 916 F.2d 1414 (9th Cir. 1990)

 

 

 United States v. Consumer Life Insurance Co., 430 U.S. 725

 

 (1977)

 

 

 United States v. Coplan, 703 F.3d 46 (2d Cir. 2012)

 

 

 UPS v. Commissioner, 254 F.3d 1014 (11th Cir. 2001)

 

 

 Wells Fargo & Co. v. United States, 2013 WL 6017366 (D. Minn.

 

 Oct. 28, 2013)

 

 

 DOCKETED CASES

 

 

 American International Group, Inc. v. United States, No. 14-

 

 765 (2d Cir. docketed Mar. 17, 2014)

 

 

 STATUTES, RULES, AND REGULATIONS

 

 

 26 U.S.C.

 

 

      § 901

 

 

      §§ 901 et seq

 

 

      § 904

 

 

      § 6213

 

 

      § 7442

 

 

      § 7482

 

 

      § 7701

 

 

      26 C.F.R.

 

 

      § 1.901-2

 

 

      § 1.904-6

 

 

 Fed. R. App. P. 13

 

 

                     LEGISLATIVE MATERIALS

 

 

 H.R. Rep. No. 83-1337 (1954)

 

 

 H.R. Rep. No. 111-443(I) (2010)

 

 

                    ADMINISTRATIVE MATERIALS

 

 

 72 Fed. Reg. 15,081 (Mar. 30, 2007)

 

 

 76 Fed. Reg. 42,036 (July 18, 2011)

 

 

                       OTHER AUTHORITIES

 

 

 Bankman, Joseph, The Economic Substance Doctrine,

 

 74 S. Cal. L. Rev. 5 (2000)

 

 

 Bittker, Boris I. & James S. Eustice, Federal Income Taxation of

 

 Corporations and Shareholders ¶ 15.21[1] [a] (7th ed. Supp.

 

 2014)

 

 

 Cummings, Jasper L., Jr., The Economic Substance Doctrine

 

 as Penalty, 138 Tax Notes 1465 (2013)

 

 

 Dolan, Kevin D., The Foreign Tax Credit Diaries -- Litigation Run

 

 Amok, 140 Tax Notes 895 (2013)

 

 

 Dolan, D. Kevin, et al., U.S. Taxation of International Mergers,

 

 Acquisitions and Joint Ventures ¶ 21.04[4] [a](2014)

 

INTRODUCTION

 

 

This appeal challenges the double taxation of petitioner-appellant The Bank of New York Mellon Corporation's ("BNY") income from a 2001 transaction with Barclays Bank, a United Kingdom financial-services firm. In the transaction, Barclays lent BNY $1.5 billion for five years at a favorable interest rate. BNY accepted the loan to serve one of its core business purposes as a commercial bank: making a profit in "net interest income" by borrowing at a favorable rate and lending or investing at a higher rate.

Barclays offered the attractive loan because it had developed a complicated loan structure that produced tax benefits for Barclays in the United Kingdom. The U.K. tax authority approved Barclays's tax treatment of the structure, and Barclays offered loans based on that structure to a number of U.S. banks. One element of the structure, necessary to achieve Barclays's U.K. tax objectives, required BNY to transfer assets to a trust with a U.K. trustee, causing the income BNY earned on those assets to become subject to U.K. taxation. Because the United States taxes the income of U.S. corporations wherever it is earned, BNY's income on those assets also remained subject to U.S. taxation. But U.S. law permits U.S. taxpayers to claim a credit for income taxes paid to a foreign country. BNY accordingly claimed foreign tax credits on its U.S. tax returns for the U.K. income tax it paid. Since those credits simply reduced BNY's U.S. tax by the amount of its U.K. tax payments, BNY did not expect the transaction to reduce its combined U.S. and U.K. tax liability. But BNY's purpose was not to save taxes; it was to earn net interest income by borrowing $1.5 billion at a favorable rate and investing the proceeds at a higher rate as part of its banking business.

The Internal Revenue Service disallowed BNY's foreign tax credits. The IRS did not challenge BNY's compliance with the statutory and regulatory requirements governing the foreign tax credit at the time. Instead, it argued that the transaction lacked "economic substance" and that BNY had no motive but tax avoidance -- even though BNY had not undertaken the transaction to avoid taxes and had earned profits that were themselves fully taxable. As a result of the disallowance, BNY must pay income tax twice -- precisely the burden that Congress enacted the foreign tax credit to avoid. For the two years immediately at issue, the amount of foreign tax credits is approximately $200 million. For the remaining three years of the transaction, hundreds of millions of dollars in further double taxation are at stake.

BNY's foreign tax credits should have been allowed. Under this Court's precedent, a court should disregard a transaction for lack of "economic substance" only if the transaction has no substance or purpose beyond the taxpayer's desire to obtain tax benefits. BNY is the taxpayer here, and it had no such desire. BNY engaged in the transaction to earn net interest income. For a commercial bank, that is the epitome of economic substance. And BNY sought no tax savings from the transaction, which simply shifted some of BNY's tax payments from the United States to the United Kingdom. Barclays enjoyed a reduction in its U.K. taxes under U.K. law, but that is irrelevant. Barclays's tax savings do not vitiate the economic substance of the transaction for BNY, and U.S. law does not make the foreign tax credit contingent on any conformity of foreign tax law to U.S. tax law.

The Tax Court ruled for the IRS, finding no economic substance in the transaction. To reach that result, the Tax Court "put the rabbit in the hat," so to speak, by treating BNY's U.K. tax payments as a "pre-tax" cost of the transaction and then ignoring all of BNY's economic benefits. Those rulings departed from precedent, disregarded the actual terms of the transaction, and ignored the rationale of the foreign tax credit. Based on these errors, the court reached the counterintuitive conclusion that a genuine and profitable transaction, falling squarely within BNY's banking business and serving no tax-avoidance purpose for BNY, was actually an abusive tax shelter. That decision should not stand.

 

JURISDICTIONAL STATEMENT

 

 

The Tax Court had jurisdiction under 26 U.S.C. §§ 6213(a) and 7442, and entered its decision on February 20, 2014. On March 5, 2014, BNY filed a notice of appeal. Fed. R. App. P. 13(a)(1); JA10. Jurisdiction in this Court rests on 26 U.S.C. § 7482(a)(1). Venue is proper because BNY's principal place of business is in New York, NY. Id. § 7482(b)(1)(B).

 

STATEMENT OF ISSUE

 

 

Whether foreign tax credits BNY claimed under Section 901 of the Internal Revenue Code for income taxes it owed and paid in the United Kingdom should be disallowed under the economic-substance doctrine.1

 

STATEMENT OF THE CASE

 

 

BNY appeals the decision of the Tax Court (Kroupa, J.) disallowing BNY's foreign tax credits. See SPA1-55 (opinion reported at 140 T.C. 15 (2013)).

A. BNY's Commercial Banking Business

BNY is a commercial bank.2 As such, BNY seeks to profit by borrowing money at relatively low interest rates -- e.g., by accepting deposits -- and lending or investing it at higher rates. JA3602, JA148-149. The difference between the return BNY earns on its loans and investments and the interest it pays on deposits and liabilities is its "net interest income." JA3602. Net interest income is a core feature of the commercial-banking business and is taxed like any other form of corporate income; in 2001, it accounted for nearly 40% of BNY's income. JA158, JA132, JA722, JA2555.

Banks employ several strategies to maximize net interest income while minimizing risk and meeting regulatory requirements. Most obviously, they seek to borrow cheaply. JA722, JA2552. In addition, banks structure their borrowing to maintain appropriate levels of liquidity while guarding against shifting interest rates. JA88-89, JA721-722, JA2559-2562. For example, banks can reduce interest-rate risk by using short-term borrowing to fund short-term investments and longer-term borrowing for longer-term investments. JA95-96, JA478, JA721-722, JA2559-2562. In 2001, BNY was increasing its investments in asset-backed securities that had a longer term than most of BNY's existing funding. JA87-88, JA722, JA725. Accordingly, BNY was seeking longer-term funding to align with these investments. JA90, JA95-96, JA149, JA734.

B. The STARS Transaction

 

1. Barclays offers BNY an attractive loan

 

In June 2001, Barclays offered BNY a $1 billion loan, for five years, at an interest rate significantly below BNY's average cost of funds. SPA4; JA91, JA298, JA363-365.3 Working with the accounting firm KPMG, Barclays had devised a way to make loans through a complicated structure that would produce tax benefits for Barclays in the United Kingdom. JA244-246, JA299, JA523, JA1206-1220. Barclays and KPMG called the structure a "Structured Trust Advantaged Repackaged Securities," or "STARS," transaction. JA1222-1238. In essence, the structure required the borrower to place income-producing assets into a trust with a U.K. trustee, which caused the income those assets produced to become subject to U.K. taxation. Barclays would make the loan by purchasing interests in the trust for cash that the trust paid to the borrower, and those steps would essentially be reversed at the end of the transaction.

By making a loan through this structure, Barclays expected to be able to take credits and deductions to reduce its other U.K. tax liabilities, provided the trust met various U.K. legal requirements. JA244-245, JA299, JA454-455; see generally Santander Holdings USA, Inc. v. United States, 977 F. Supp. 2d 46, 48-49 (D. Mass. 2013) (describing similar transaction). Given these anticipated U.K. tax benefits, Barclays was willing and able to attract potential counterparties by offering the loan at a low cost. JA246, JA299, JA523, JA2744-2745, JA3130. Barclays proposed loans based on the STARS structure to a number of U.S. counterparties and entered into transactions with several of them. SPA19. In 2001, Barclays disclosed the first such transaction to the U.K. tax authority, then known as Inland Revenue. SPA19-20; see JA3558. After review, Inland Revenue approved Barclays's tax treatment of the STARS structure under U.K. law. SPA20; see JA3585.

 

2. BNY accepts Barclays's loan

 

Barclays's proposal immediately captured BNY's interest because it offered attractive long-term funding at an unusually low cost. JA90-94. As BNY's treasurer explained, the proposed loan amounted to an "exceedingly cheap deposit" that "came at a time when [BNY] w[as] seriously building [its] investment portfolio." JA92; supra p. 5. Other BNY executives, including the CEO, agreed: The STARS transaction offered "exceptionally attractive" financing in a substantial amount for a long term that "create[d] a greater level of stability for [BNY's] assets." JA734; see JA176, JA298, JA479. In short, STARS presented a "very attractive" arrangement that served a "core function" of the bank -- earning net interest income. JA176. BNY accordingly accepted Barclays's proposal for the purpose of obtaining substantial long-term funding at an advantageous rate. JA90-94; see JA176, JA194, JA206, JA298, JA300, JA363-365, JA401, JA479, JA734.

BNY understood that Barclays expected to obtain tax benefits in the United Kingdom and that Barclays would not provide a loan at the favorable rate without the trust structure that produced those benefits. JA93, JA175, JA187, JA370-371; see JA246, JA254, JA523, JA556. But from its own perspective, BNY expected the transaction to be tax-neutral. Although participating in STARS would subject some of BNY's income -- already taxed in the United States -- to U.K. taxation as well, BNY expected to mitigate that double taxation by claiming foreign tax credits on its U.S. tax returns to reduce its U.S. tax by the amount of U.K. tax it paid. BNY thus did not expect the transaction to increase or reduce its worldwide tax liability, except to the extent that it would owe additional U.S. tax on its increased net interest income. JA367-368, JA393; see JA176, JA300, JA351, JA363-364, JA370, JA381, JA391.

BNY and Barclays negotiated the terms of the transaction over several months. JA3617-3634. Barclays dictated the trust structure to achieve its U.K. tax objectives. JA93. But the parties actively negotiated the financial terms, including the size and cost of the loan and the amount of assets BNY would contribute to the trust. In particular, BNY sought to "upsiz[e] the transaction" so as to "borrow[ ] as much as it could at the favorable rate." JA206, JA369; see JA91, JA194-196, JA201-202, JA206-207, JA241-242, JA246, JA300. Barclays ultimately agreed to increase the loan to $1.5 billion and to reduce the rate to approximately 300 basis points below LIBOR. JA91, JA113, JA150, JA209, JA299, JA339, JA351, JA506-507. This interest rate was "substantially" below BNY's average cost of funds at the time, JA93, and BNY did not usually raise $1.5 billion in funding in a single transaction, JA94, JA2564. BNY planned to use the loan proceeds to continue expanding its investment portfolio, JA92, JA94, JA151; see supra p. 5, and projected that it would earn a significant profit by doing so, JA372, JA1511-1512, JA1519, 1597-1600, JA2058, JA2069, JA2180.

 

3. Barclays makes the loan through the STARS structure

 

Under the STARS structure, Barclays's loan took the form of an investment in a trust, funded by the borrower, whose trustee resided in the United Kingdom. This structure permitted Barclays to obtain U.K. tax benefits because U.K. law -- unlike U.S. law -- taxed the transaction as an equity investment by Barclays in the trust, rather than as a loan, and provided certain credits and deductions to Barclays if the trust met certain requirements. To achieve that U.K. tax treatment, Barclays required the structure to have several features that made it unusually complex. But most of those features were relevant only to Barclays's tax position under U.K. law, so we describe the transaction in simplified form.4

First, BNY created the "STARS Trust" and funded it by contributing some of BNY's existing assets, in a net amount of approximately $7.8 billion. JA3519, JA3521-3524, JA3528-3529. The Trust issued shares called "units" and made monthly distributions to unitholders of income earned on Trust assets. JA891-916, JA3524-3526. In return for its contribution of assets, BNY received shares in the Trust known as the Class A and B units. JA3528-3529. BNY controlled the Trust assets through subsidiaries that served as Trustee and Manager. JA3524-3525.5 To satisfy Barclays's U.K. tax objectives, a BNY subsidiary based in the United Kingdom served as Trustee, causing the income produced by the Trust assets to be subject to U.K. taxation. JA253, JA3524, JA3533-3534.

Barclays made the loan by purchasing Trust shares called the Class C and D units for approximately $1.5 billion in cash, which the Trust paid to BNY to redeem the Class B unit. JA3529-3531. BNY agreed to repay that principal to Barclays by purchasing Barclays's Trust units for approximately $1.5 billion at the end of five years, at which time the Trust assets would revert to BNY. JA929-940, JA3537, JA3539-3541, JA3543-3544. To satisfy Barclays's U.K. tax objectives, infra p. 15, the Trust documents provided that Barclays, as holder of the Class C unit, would be entitled to monthly distributions of nearly all of the Trust income, less expenses and less one percent of Trust income due to BNY as holder of the Class A unit; but these distributions would go into a "blocked account" and then be recontributed to the Trust. JA3525-3526. Although the blocked account was in Barclays's name, Barclays had no access to it. JA3525-3526, JA3532-3533.6

To implement the interest rate, the parties contracted to make three monthly payments -- some by BNY, some by Barclays. One of these payments required BNY to pay a monthly LIBOR-based amount, reduced by a discount that the parties referred to as the "spread." The spread did not depend on LIBOR, but was set in advance by a formula the parties calculated to reflect approximately half the pre-tax value of Barclays's expected U.K. tax benefits. SPA44 n.14; JA3538-3539, JA3541-3542. By reducing BNY's costs for obtaining the loan, the spread increased BNY's net interest income from the transaction; over the life of the transaction, the spread contributed nearly $250 million to BNY's net interest income. JA2991(Fig. 9). On net, the three payments the parties made each month -- with one of BNY's payments reduced by the spread -- resulted in BNY paying the negotiated effective interest rate of 300 basis points below one-month LIBOR. Because the spread did not decrease with LIBOR, Barclays was obligated to make net payments to BNY whenever one-month LIBOR was less than 3%. JA134, JA150, JA179, JA2593, JA3581, JA3638.

In addition to these central elements, the parties took other steps to secure their rights and guard against contingencies. As collateral for the loan, BNY granted Barclays a security interest in $2.25 billion of Trust assets. JA299, JA505, JA3547-3551. BNY agreed to guarantee its subsidiaries' financial obligations, JA3555, and to make additional payments to Barclays if the Trust did not qualify for Barclays's intended U.K. tax treatment or did not earn specified minimum income, JA1308, JA3559-3560. The parties also agreed that either of them could terminate the transaction early, JA3544, although they both anticipated that the deal would continue for the full five years, JA92, JA115, JA175, JA207, JA251, JA277, JA366, JA483.

The STARS transaction closed in November 2001. BNY received the $1.5 billion loan and recorded the proceeds as a deposit in its Cayman branch, which BNY commonly used for LIBOR-based deposits. JA3531. As the Tax Court found, those funds remained "available for [BNY] to use in its banking business" throughout the transaction. SPA66; see SPA15; JA94, JA151-152, JA3531. Each month, the parties made the payments implementing the interest rate on the loan, with one of BNY's payments offset by the spread. JA3575-3576, JA3581, JA3583. The transaction was wound down after five years, when the parties made the final monthly payments, BNY repaid the loan by purchasing Barclays's Class C and D units, and the Trust assets reverted to BNY. JA3583-3584.7

C. Taxation Of The STARS Transaction

 

1. BNY's U.K. tax

 

For BNY, U.K. taxation was relatively straightforward. Under U.K. law and the governing U.S.-U.K. tax treaty, the income produced by the assets in the Trust was taxable in the United Kingdom because the Trustee, a subsidiary of BNY, legally resided there. JA253. For the type of trust used here, U.K. law imposed a 22% tax on trust income. JA299, JA2793-2794, JA3584-3585. Therefore, for each $100 in Trust income, BNY owed $22 in U.K. taxes. In total, BNY paid $98,607,973 and $100,285,767 to the United Kingdom as tax on the Trust income in 2001 and 2002, respectively. JA3585-3586.

 

2. Barclays's U.K. tax

 

Barclays's U.K. tax situation was far more complicated. Barclays's handling of it was approved by U.K. tax authorities and is not at issue, supra pp. 6-7, but because it drove the structure of the transaction, we summarize how the structure produced U.K. tax benefits for Barclays.

For the type of trust Barclays sought to use, supra n.5, the United Kingdom imposes income tax both at the level of the trust itself and on U.K. unitholders. The unitholder's tax is based not on actual distributions of income, but on "deemed payments," calculated as the unitholder's proportionate share of trust income available for distribution, "grossed up" by the 22% tax owed at the trust level. JA465, JA469-470, JA2794-2805, JA2884-2885, JA3584-3585.

Although Barclays had no access to the blocked account, U.K. law treated Barclays as the owner of the Class C unit and, therefore, entitled to nearly 100% of the Trust income. Supra pp. 10-11. Consequently, if the Trust earned $100, Barclays would report a taxable deemed payment of $100 ($78 remaining for distribution after the 22% Trust tax, grossed up to $100 to reflect those taxes). JA244-245, JA2884-2885, JA2893.8 The deemed payment was taxable at the 30% U.K. corporate rate, or $30. But if the Trust met certain requirements, supra n.5, Barclays could claim a credit for the U.K. tax imposed on BNY at the Trust level, equal to 22% of the $100 deemed payment, or $22. This credit reduced Barclays's tax liability to $8 per $100 of Trust income. JA245.

A further U.K. tax consequence of the STARS structure offset this liability and yielded net U.K. tax benefits for Barclays. If the transaction counted as part of Barclays's "financial trade" -- i.e., its business as a lender -- Barclays could deduct from its taxable income the amounts that were recontributed to the Trust from the blocked account. Supra pp. 10-11; JA246-247, JA454, JA2816-2821. Thus, for every $100 of Trust income, $78 (the amount remaining after payment of the $22 Trust tax) went into the blocked account and then back to the Trust, and Barclays could claim a $78 deduction. Given Barclays's 30% tax rate, this deduction translated into a $23.40 reduction in Barclays's U.K. tax ($78 x 30%). Subtracting the $8 in tax computed above, Barclays obtained a net after-tax benefit of $15.40 per $100 of Trust income that it could use to reduce its other U.K. tax liabilities. JA245.9

 

3. BNY's U.S. tax

 

Although BNY incurred and paid a 22% U.K. tax on its income from the Trust assets, BNY as a U.S. corporation was also subject to U.S. tax on that income. Subject to complex limitations and requirements, the Internal Revenue Code and Treasury regulations allow a U.S. taxpayer to mitigate such double taxation by taking a dollar-for-dollar foreign tax credit against its U.S. tax liability for amounts it pays as income tax to a foreign government. See 26 U.S.C. § 901.

When it decided to enter into the STARS transaction, BNY expected to claim foreign tax credits for its U.K. tax payments. Supra pp. 7-8. As with many international income-producing transactions, the transaction would not have been rational for BNY if those credits were not available to eliminate double taxation. JA176, JA300, JA351, JA363-365, JA368, JA370, JA381, JA391, JA396. But BNY did not expect the foreign tax credits to produce any net tax benefit; they would not reduce its combined U.S. and U.K. tax on the Trust's earnings over the life of the transaction, because each dollar in foreign tax credits would merely reflect a dollar of tax BNY paid to the United Kingdom. Id.

In 2001 and 2002, BNY reported the income earned on the Trust assets on its U.S. returns as foreign-source income, subject to U.S. income tax. JA2082-2085. BNY deducted from its taxable income the interest it paid on the loan and expenses related to the transaction. JA3582.10 And BNY claimed foreign tax credits for its U.K. tax in the amounts of $98,607,973 and $100,285,767, respectively. JA3579.

D. Tax Court Proceedings

In 2009, the IRS issued a Notice of Deficiency disallowing BNY's foreign tax credits. JA30-49, JA3512. The Notice did not challenge BNY's compliance with the statutory and regulatory requirements governing the foreign tax credit. See JA45-46. The IRS instead asserted that the STARS transaction lacked "economic substance." JA45. The disallowance of BNY's foreign tax credits will effectively require BNY to pay both U.K. and U.S. taxes on its income from the Trust assets.

BNY petitioned the Tax Court for a redetermination of deficiencies. See JA13-29. After a three-week bench trial, the court ruled for the IRS, relying exclusively on the economic-substance doctrine. SPA3, SPA24-55. Under this Court's precedent, that doctrine turns on (1) the taxpayer's objective expectation of profit, and (2) the taxpayer's subjective purpose for entering into the transaction. Gilman v. Commissioner, 933 F.2d 143, 148 (2d Cir. 1991). The Tax Court acknowledged that the transaction gave BNY the opportunity to borrow $1.5 billion for five years to lend or invest in its banking business. SPA4-5, SPA10, SPA15. It nevertheless concluded that the STARS transaction had no economic substance and that BNY had no subjective purpose for participating in it except tax avoidance. The court made several legal rulings to reach that result.

First, in assessing the transaction's profitability, the court treated BNY's U.K. tax payments as "non-tax" "transaction costs" that reduced BNY's expected profits. SPA32. At the same time, it excluded from BNY's profits the income BNY earned from the Trust assets -- i.e., the very income that gave rise to the U.K. tax payments -- on the ground that the assets would have generated the same income regardless of BNY's participation in the transaction. SPA35-36, SPA47-48. The court acknowledged that the Fifth and Eighth Circuits had rejected this treatment of foreign taxes -- indeed, the Fifth Circuit had reversed the Tax Court precedent on which the court relied. Nonetheless, the court adhered to its prior decision because it was "not bound" by those precedents. SPA32 n.9.

Second, the Tax Court disregarded the spread, which reduced BNY's interest costs, and instead evaluated the transaction as if BNY had paid a higher interest rate. SPA41-47. Although the spread was a private obligation undertaken by Barclays to give BNY the negotiated favorable interest rate, supra p. 11, the Tax Court rejected the spread as an impermissible "tax effect" because it reflected a portion of Barclays's U.K. tax benefits. SPA44.

Finally, the court refused to consider the $1.5 billion loan and the net interest income BNY expected to earn by investing the loan proceeds. The court asserted that the economic-substance inquiry must ignore all aspects of a transaction except for that aspect that "produces the disputed tax benefit." SPA30. In the court's view, "[t]he disputed foreign tax credits were generated by circulating income through the STARS structure," and the court therefore limited its analysis to the creation and funding of the STARS Trust. SPA31. According to the court, the net income BNY earned by investing the loan proceeds arose from BNY's separate investment activities and could not be attributed to STARS.

These legal rulings predetermined the outcome. Having ruled that any assessment of the transaction's profitability must count U.K. taxes as a cost but exclude all economic benefits BNY derived, the court found that the transaction provided no objective opportunity for profit. And having rejected BNY's actual business purpose for entering into the transaction as either irrelevant or a "tax effect," the court found no subjective purpose but tax avoidance. The court accordingly upheld disallowance of BNY's foreign tax credits.11 Although the decision addressed only 2001 and 2002, it likely will also control BNY's tax liability from 2003 through 2006, when the transaction concluded.

 

STANDARD OF REVIEW

 

 

This Court reviews Tax Court decisions "'in the same manner and to the same extent as decisions of the district courts.'" Scheidelman v. Commissioner, 682 F.3d 189, 193 (2d Cir. 2012) (quoting 26 U.S.C. § 7482(a)(1)). "The general characterization of a transaction for tax purposes is a question of law." Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978); see also Knetsch v. United States, 364 U.S. 361, 365 (1960). The Court thus reviews de novo the Tax Court's ultimate characterization of the transaction, while reviewing its underlying factual findings for clear error. Newman v. Commissioner, 902 F.2d 159, 162 (2d Cir. 1990); see also Estate of Stewart v. Commissioner, 617 F.3d 148, 154 (2d Cir. 2010). "[F]indings based upon an improper standard, a mistaken impression of applicable legal principles, or a misunderstanding of the governing rule of law may be corrected as a matter of law." Andrew Crispo Gallery, Inc. v. Commissioner, 86 F.3d 42, 46 (2d Cir. 1996) (internal quotation marks and citations omitted).

While consistently applying de novo review to the Tax Court's legal standards, some decisions of this Court describe the conclusion that a transaction lacks economic substance as a finding of fact to be reviewed for clear error. See, e.g., Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990). As other circuits have recognized, that approach is inconsistent with Frank Lyon. See, e.g., Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 780-781 & n.1 (5th Cir. 2001); Sacks v. Commissioner, 69 F.3d 982, 986 (9th Cir. 1995); see also Sala v. United States, 613 F.3d 1249, 1252 (10th Cir. 2010) ("[W]hether a transaction lacks economic substance is a question of law."); IES Indus., Inc. v. United States, 253 F.3d 350, 351 (8th Cir. 2001) (economic-substance analysis is a "question of law"). Therefore, consistent with this Court's decision in Newman, the Court should review the Tax Court's underlying factual findings for clear error, but should review de novo both the legal standards the court applied and its ultimate conclusion under those standards.

 

SUMMARY OF ARGUMENT

 

 

Under the economic-substance doctrine, a court should disregard a transaction for tax purposes only if it has "no substance or purpose aside from the taxpayer's desire to obtain [a] tax benefit." Goldstein v. Commissioner, 364 F.2d 734, 741-742 (2d Cir. 1966). Here, BNY entered into the STARS transaction not to reduce its overall taxes, but to borrow on advantageous terms to earn net interest income. That is the quintessential substantive business activity of a commercial bank. It is undisputed that BNY reported its income accurately on its U.S. tax returns and met all statutory and regulatory requirements governing the foreign tax credit at the time. Disallowing BNY's foreign tax credits effectively subjects BNY to double taxation, contrary to Congress's purposes in enacting the credit.

The Tax Court nonetheless concluded that BNY had no valid nontax reason to accept a low-cost $1.5 billion loan and no objectively reasonable prospect of profiting except through tax avoidance. To reach that result, the court made a series of legal errors that led it to overstate BNY's economic costs and to disregard all of BNY's economic benefits. First, the court counted BNY's U.K. tax as a cost of the transaction in assessing BNY's prospects of pre-tax profit. That decision conflicts with decisions of the Fifth and Eighth Circuits, which recognize that treating foreign tax as a pre-tax economic cost is both illogical and irreconcilable with basic tax-law principles. The court compounded that error by holding, without authority, that the income generated by the Trust assets could not lend economic substance to the transaction, even though it was that income that gave rise to BNY's U.K. tax in the first place.

Second, the court ignored the spread, dismissing it as a "tax effect." But Barclays agreed to make a loan at a favorable rate, and it fulfilled that obligation by reducing BNY's interest costs by the spread. The law required the Tax Court to consider the terms of the transaction as they actually occurred, including the spread. Barclays's motivations and its position under U.K. tax law are irrelevant. As to BNY, the spread was not a "tax effect," but a reduction in the cost (and corresponding increase in profit) of its basic business.

Finally, the Tax Court erred in disregarding the $1.5 billion loan and the return BNY expected to earn by investing the loan proceeds. The court recognized that the parties negotiated and executed the transaction as one integrated package. BNY would not have agreed to the transaction without the loan, and Barclays would not have offered the favorable loan without the Trust. The Tax Court's reasons for severing the loan from the Trust and ignoring BNY's investment income are meritless and would impair numerous routine financing transactions.

In each of these rulings, the Tax Court departed from precedent and contravened the intent of the foreign tax credit. And the court disregarded the real terms of the transaction in favor of an artificial characterization, not contemplated by any party, that was preordained to fail economic-substance scrutiny. The decision should be reversed.

 

ARGUMENT

 

 

I. BNY IS ENTITLED TO FOREIGN TAX CREDITS FOR U.K. TAXES IT

 

PAID ON THE ECONOMICALLY SUBSTANTIAL STARS TRANSACTION

 

 

A. Congress Intended The Foreign Tax Credit To Mitigate Double Taxation

Congress's "primary design" in allowing foreign tax credits -- and BNY's purpose in claiming them -- is "to mitigate the evil of double taxation." Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932). The United States taxes the worldwide income of U.S. taxpayers, even when a foreign country also taxes the taxpayer's income. Absent the foreign tax credit, a U.S. taxpayer earning income abroad would pay tax on that income in both the foreign country and the United States. See PPL Corp. v. Commissioner, 133 S. Ct. 1897, 1901 n.2 (2013).

The foreign tax credit alleviates this double taxation by permitting U.S. taxpayers to credit their U.S. income tax for income taxes paid to a foreign country. 26 U.S.C. § 901(b)(1). Through the foreign tax credit and related tax treaties, the United States cedes primary taxing jurisdiction to foreign governments as to particular income, inevitably reducing U.S. tax receipts. Id. §§ 901 et seq.12 But claiming the credit does not allow a taxpayer to escape taxation. It simply fulfills the congressional purpose that all income, domestic or foreign, should be taxed only once.

Although the "purpose of the foreign tax credit can be simply stated," in its application "the foreign tax credit regime is a byzantine structure of staggering complexity." Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 15.21[1] [a] (7th ed. Supp. 2014). Congress and the IRS have developed an exacting framework that permits foreign tax credits only in carefully delineated circumstances. Under the "technical taxpayer" rule, for example, a taxpayer cannot claim a credit unless it bears legal liability for the foreign tax. See 26 C.F.R. § 1.901-2(f); Biddle v. Commissioner, 302 U.S. 573, 579-581 (1938).

And a taxpayer who bears legal liability for and pays a foreign tax might still be ineligible if the foreign country "refunded, credited, rebated, abated, or forg[ave]" the taxpayer's foreign tax payment, 26 C.F.R. § 1.901-2(e)(2)(i), or used the payment "to provide a subsidy by any means to the taxpayer, a related person . . ., or any party to the transaction or to a related transaction," 26 U.S.C. § 901(i)(1).

A taxpayer who is not disqualified under these provisions may claim foreign tax credits only up to complex limits. See 26 U.S.C. § 904(a); Grunebaum v. Commissioner, 420 F.2d 332, 333 (2d Cir. 1970). And the taxpayer may credit only foreign "income, war profits, and excess profits taxes." 26 U.S.C. § 901(b)(1); 26 C.F.R. § 1.901-2(a)(1). Numerous other categories of taxes are not creditable, nor are interest and penalties. See Bittker & Eustice ¶ 15.21[1] [a]. Congress has repeatedly revised and supplemented these requirements to provide guidance to taxpayers and to address transactions Congress viewed as problematic. See id. ¶ 15.21.

Critically, this framework does not require that the foreign country's tax law conform to U.S. tax law. If the taxpayer legally owes and actually pays foreign income tax and meets the statutory and regulatory requirements, then the credit is available (up to designated limits) even if the foreign jurisdiction's law treated the transaction differently than U.S. law would have treated it. See, e.g., 26 C.F.R. § 1.904-6(a)(1)(iv) (permitting credit when foreign tax is imposed "on an item of income that does not constitute income under United States tax principles").

Finally, although the United States agreed through the foreign tax credit to cede certain tax revenues to foreign governments, U.S. law imposes no duty on taxpayers to prefer domestic transactions to foreign transactions. The foreign tax credit does "not require" a U.S. taxpayer "to alter its form of doing business, its business conduct or the form of any business transaction in order to reduce its liability under foreign law for tax." 26 C.F.R. § 1.901-2(e)(5)(i). Rather, the taxpayer is free to structure its business as it chooses, including by earning income through a foreign subsidiary or placing assets into a foreign corporation, even if doing so subjects the taxpayer to foreign tax. See Dolan et al., U.S. Taxation of International Mergers, Acquisitions and Joint Ventures ¶ 21.04[4] [a] (2014). The taxpayer "is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes." Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (Hand, J.), aff'd, 293 U.S. 465 (1935).

B. The Economic-Substance Doctrine Applies In Limited Circumstances To Disregard Transactions A Taxpayer Undertakes For No Purpose But Tax Avoidance

Where it applies, the economic-substance doctrine precludes a taxpayer from claiming tax benefits for a transaction that "'can not [sic] with reason be said to have purpose, substance, or utility apart from [its] anticipated tax consequences.'" United States v. Coplan, 703 F.3d 46, 91-92 (2d Cir. 2012) (alterations in original). Courts developed the doctrine in recognition that applying a statutory tax benefit to a transaction that serves "no other motive but to escape taxation" might violate congressional intent. Commissioner v. Transport Trading & Terminal Corp., 176 F.2d 570, 572 (2d Cir. 1949) (Hand, J.). At the same time, this Court has called for a "cautious approach" in applying the doctrine to disregard transactions that meet the requirements of the Tax Code, to avoid encroaching upon Congress's role in crafting tax policy. Nassau Lens Co. v. Commissioner, 308 F.2d 39, 45-46 (2d Cir. 1962) (Marshall, J.).

Courts have applied the economic-substance doctrine to disallow tax benefits where "there was nothing of substance to be realized" by the taxpayer from the transaction "beyond a tax deduction." Knetsch v. United States, 364 U.S. 361, 366 (1960). In Knetsch, for example, the Supreme Court disallowed a deduction for interest paid on indebtedness where the taxpayer -- who had purchased annuity bonds funded by nonrecourse debt and borrowed against the annuities to pay the interest -- was not actually "indebted" to the lender. Id. at 365-366. Similarly, in Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), this Court disregarded a transaction the taxpayer had undertaken "solely" to reduce her taxes. Id. at 740. To avoid taxes on her winnings in the Irish Sweepstakes, Mrs. Goldstein took out bank loans, invested the proceeds in Treasury notes maturing at lower interest, and prepaid the interest on the loans. Id. at 736. Because she had borrowed at a high rate and invested at a lower rate -- an inherently losing proposition -- Mrs. Goldstein expected the transaction to lose money; but she expected the tax savings from deducting the prepaid interest to exceed the loss. Id. at 739. This Court held that Mrs. Goldstein could not take a deduction for interest paid because the loan arrangement "lack[ed] all substance, utility, and purpose" except for her desire "to reduce [her] taxes." Id. at 742; see also, e.g., Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1343, 1345, 1357-1360 (Fed Cir. 2006) (disregarding transaction that reduced taxes by creating net losses); Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2d Cir. 2003) (same).

In contrast, courts have rejected economic-substance challenges in cases involving genuine transactions between independent entities that serve substantial nontax business purposes. For example, in United States v. Consumer Life Insurance Co., 430 U.S. 725 (1977), the Supreme Court held that a reinsurance arrangement negotiated at arm's length had economic substance -- even though the reinsurer would eventually recoup the amount it paid out on claims through "refunds" from the primary insurer -- because the agreement "served valid and substantial nontax purposes" of risk allocation. See id. at 737-739; see also, e.g., Cottage Sav. Ass'n v. Commissioner, 499 U.S. 554, 567-568 (1991). As the Court later explained:

 

where . . . 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, the Government should honor the allocation of rights and duties effectuated by the parties.

 

Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978).

To determine whether a transaction satisfies the economic-substance test, this Court applies a "flexible" analysis that examines both the transaction's objective substance and the taxpayer's subjective motivations. Gilman v. Commissioner, 933 F.2d 143, 148 (2d Cir. 1991). Specifically, the Court asks (1) whether the taxpayer had an objectively reasonable expectation of profit from the transaction apart from tax effects; and (2) whether the taxpayer had a subjective nontax business purpose for entering into the transaction. Id. at 147-148. Under this test, a court should not disregard a transaction unless it has "no business purpose or economic effect" except tax avoidance. Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990).

Because the doctrine is thus concerned with transactions that lower a taxpayer's tax bill, it rarely or never has purchase in the context of the foreign tax credit.13 Unlike other tax attributes commonly at issue in economic-substance cases, the foreign tax credit is a method of allocating a taxpayer's worldwide tax liability, not a way to reduce it. A taxpayer could not expect to achieve any tax-avoidance objective -- let alone pursue "no other motive but to escape taxation," Transport Trading, 176 F.2d at 572 -- by subjecting assets already taxed by the United States to additional foreign taxation and claiming only a dollar-for-dollar credit (up to statutory limits) for the foreign taxes.

Moreover, when a taxpayer owes both U.S. and foreign tax on income earned in a genuine transaction that meets the demanding requirements of the Code and regulations, denying a foreign tax credit on economic-substance grounds contravenes Congress's intent to mitigate double taxation. Supra pp. 23-24. It is thus unsurprising that, from enactment of the foreign tax credit in 1918 until the IRS's recent attack on STARS-type transactions,14 no court -- apart from two decisions later reversed on appeal -- applied the economic-substance doctrine to disallow an otherwise valid foreign tax credit.15

C. STARS Had Ample Economic Substance For BNY

This case should not be the first in which a court of appeals affirms the disallowance of foreign tax credits for alleged lack of economic substance. STARS was a substantial transaction negotiated at arm's length between two independent parties. Barclays lent BNY $1.5 billion of real money, and the Tax Court specifically found that the loan proceeds "were available for [BNY] to use in its banking business throughout the STARS transaction." SPA66. BNY reported its income from the transaction accurately, satisfied all statutory and regulatory requirements in place at the time, and actually owed and paid the hundreds of millions of dollars in U.K. income taxes it sought to credit. Without the foreign tax credits, BNY will have to pay those taxes twice.

BNY thus did not enter into the transaction to escape taxation. The fact witnesses testified unanimously: BNY's purpose in accepting Barclays's proposal was to obtain a substantial loan at a "very advantageous" price. JA174; see supra p. 7. Unlike Mrs. Goldstein, supra pp. 27-28, BNY neither expected nor sought a tax reduction. As BNY's CEO explained, "[i]t was intrinsic in [BNY's] business to be able to maximize net interest income," and accepting Barclays's "very attractive" loan was "beneficial to th[at] business." JA722.16

Given the low interest rate, BNY reasonably expected to earn significant net interest income. JA92, JA94; supra pp. 7, 8-9. As reduced by the spread, the interest rate on the Barclays loan was 300 basis points below one-month LIBOR -- "substantially" lower than BNY's average cost of funds, JA93; see JA94, JA149, JA176, JA208-209, JA213, JA613, JA2050, JA2564; supra pp. 8, 11. By reducing BNY's costs, the spread contributed nearly $250 million to BNY's net interest income over the life of the transaction. JA2991.

In addition, BNY expected to earn a return on the loan proceeds by investing them in its expanding portfolio. JA150. It was standard BNY practice in 2001 to assume a conservative return on prospective investments of 25 basis points above LIBOR. Id. That return alone would have yielded significant net interest income given the reduced interest rate on the loan. Using similar assumptions, BNY projected shortly before closing that, "holding everything else equal," the transaction would yield hundreds of millions of dollars in net interest income. JA372, JA2180. Other contemporaneous analyses projected profits of similar or even larger magnitude. See JA1511, JA1519, JA1598, JA2058, JA2069.

At trial, BNY presented expert testimony analyzing BNY's objective prospect of pre-tax profit. See JA496-497, JA512, JA3001-3004. That analysis demonstrated that, at closing, BNY could reasonably have expected a pre-tax profit of over $1.6 billion, comprising net interest income from the Barclays loan, plus income earned on the assets in the STARS Trust, less BNY's expenses and advisory costs. JA3002-3003.17 Even the IRS's expert conceded at trial that STARS represented a "very profitable transaction" for BNY. JA611-612.

Critically, BNY did not expect to reduce its worldwide tax by claiming foreign tax credits. By participating, BNY subjected a portion of its income to both U.K. and U.S. tax, as the law allows it to do. Claiming foreign tax credits simply mitigated that double taxation. As another court observed in rejecting the government's challenge to a similar transaction, "[i]t is true that the U.K. received an amount in taxes from [the bank] that but for the transaction would have gone to the U.S. Treasury, but that transfer produced no advantage to [the bank]. It was still out the same amount of tax, regardless which country it was paid to." Santander, 977 F. Supp. 2d at 53.

Of course, BNY's willingness to enter into the transaction depended in part on its expectation that the transaction would qualify for foreign tax credits. See JA351, JA409.18 But that is the point of the credit: to facilitate U.S. taxpayers' participation in foreign transactions that would otherwise be irrational due to double taxation. It would make no sense to "use the reason Congress created the tax benefits as a ground for denying them." Sacks v. Commissioner, 69 F.3d 982, 991 (9th Cir. 1995). The fact that BNY anticipated that the transaction would be tax-neutral, and therefore financially feasible, because of foreign tax credits thus does not invalidate the transaction. "[E]ven a 'major motive' to reduce taxes will not vitiate an otherwise substantial transaction," Consumer Life, 430 U.S. at 739, and here, BNY expected no tax reduction.

Barclays, of course, was motivated to achieve U.K. tax benefits. By making a loan through a particular structure, Barclays could claim credits and deductions that reduced its overall U.K. tax liability, and as a result, it was willing to offer the loan at a bargain rate. But the proper focus under the economic-substance doctrine is on the motivations of "the taxpayer" whose tax position is under scrutiny. Goldstein, 364 F.2d at 741; see also, e.g., Frank Lyon, 435 U.S. at 576-577. A foreign counterparty's foreign tax motivation does not make a transaction tax-motivated from the perspective of the U.S. taxpayer. Indeed, if a U.S. taxpayer's own tax-planning objectives cannot "vitiate an otherwise substantial transaction," Consumer Life, 430 U.S. at 739, then the tax objectives of a foreign counterparty under foreign law cannot possibly be disqualifying.

Nor does the fact that U.S. law might have taxed the transaction differently than U.K. law deprive the transaction of economic substance for BNY or taint BNY's motivations. As discussed above, U.S. law defers to the tax laws of the foreign jurisdiction and allows foreign tax credits by treaty and statute even where the foreign government taxes income differently or provides different credits and deductions than U.S. law would do. Supra pp. 25-26. Applying the economic substance doctrine to disallow BNY's otherwise-valid foreign tax credits because Barclays gained a U.K. tax advantage that may not have conformed to U.S. tax principles would engraft a requirement onto the foreign tax credit that Congress has never imposed. BNY's purposes alone should be dispositive, and those purposes were clear -- to take advantage of a singular opportunity to earn substantial net interest income.

The Tax Court's judgment is thus plainly incorrect. BNY did not engage in the STARS transaction to escape taxation, but to make money in its banking business by deploying its assets in a manner that yielded significant net interest income. The Tax Court thought BNY did not engage in "substantive . . . activity" in the United Kingdom, SPA52, but for a commercial bank, making money by borrowing and investing is the very definition of substantive activity. The STARS transaction unquestionably served that business objective. Under any standard of review, the decision should be reversed.19

 

II. THE TAX COURT'S CONTRARY DECISION RESTS ON LEGAL

 

ERRORS

 

 

Given BNY's obvious economic purpose for accepting the Barclays loan, one might ask how the Tax Court could have concluded that the transaction had no economic substance and that BNY's "true motivation" was "tax avoidance." SPA36. It did so by calling BNY's U.K. tax payments a "pre-tax" economic cost, ignoring the actual terms of the transaction, and disregarding every economic benefit BNY derived. That analysis was flawed at every turn.

A. The Court Erred In Treating Foreign Taxes As A Cost While Ignoring BNY's Income From The Trust Assets

The correct question for the Tax Court in evaluating BNY's expectation of profit was simply whether BNY's prospective revenues from the STARS transaction exceeded its expenses pre-tax. See, e.g., Goldstein, 364 F.2d at 739-740. On the revenue side, BNY's taxable income included its total earnings on the Trust assets, including any amounts used to pay U.K. tax. The Tax Court reached a contrary conclusion, however, based on two errors.

1. First, the court treated BNY's U.K. taxes as a "non-tax" "transaction cost" that counted against BNY's prospects for pre-tax profit. SPA32 & n.9. To support that approach, the court relied exclusively on its own decision in Compaq Computer Corp. v. Commissioner, 113 T.C. 214 (1999). As the court acknowledged, however, the Fifth Circuit reversed that decision, and the Eighth Circuit has also rejected this approach. As these courts recognized, treating foreign taxes as an economic cost in the pre-tax profitability analysis is illogical and inconsistent with black-letter tax law.

In Compaq, the taxpayer, Compaq, sought to offset capital gains by buying and selling shares in Royal Dutch Petroleum, a foreign company. See Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 779-780 (5th Cir. 2001). Compaq bought the shares right before the dividend record date, thus purchasing stock that was pregnant with immediately forthcoming dividends. Royal Dutch paid Compaq a gross dividend of about $22.5 million, from which it withheld a 15% Netherlands tax ($3.4 million). After collecting the dividend, Compaq immediately sold the shares at a loss. Compaq claimed $3.4 million of foreign tax credits to offset its U.S. tax on the dividend income and used its loss on the sale of the shares to offset unrelated capital gains.

The Tax Court disallowed the foreign tax credits, finding "no reasonable opportunity for profit apart from the income tax consequences of the transaction." Compaq, 277 F.3d at 782. The court reached this result using what the Fifth Circuit called "a curious method of calculation," id.: To determine Compaq's profit, the court subtracted Compaq's loss on the sale, not from its gross dividend of $22.5 million, but from the net dividend remaining after subtracting the $3.4 million Netherlands tax. The court then ignored the benefit of the $3.4 million foreign tax credit and concluded that the transaction resulted in an overall loss. Id. As the Fifth Circuit put it, the Tax Court "assessed neither the transaction's pre-tax profitability nor its post-tax profitability," but rather "assessed profitability by looking at the transaction after Netherlands tax had been imposed but before considering U.S. income tax consequences." Id. In other words, "the court treated the Netherlands tax as a cost of the transaction, but did not treat the corresponding U.S. tax credit as a benefit of the transaction." Id.

The Fifth Circuit rejected this "half pre-tax, half after-tax" approach. 277 F.3d at 782. As the court explained, "[t]o count" taxes "only when they subtract from cash flow is to stack the deck against finding the transaction profitable." Id. at 785. Moreover, discriminating between foreign and domestic taxes in the pretax profitability analysis negates Congress's purpose in enacting the foreign tax credit, which Congress expected would "in effect treat[ ] the taxes imposed by the foreign country as if they were imposed by the United States." H.R. Rep. No. 83-1337, at 76 (1954). Agreeing with the Eighth Circuit's decision in a similar case, the Fifth Circuit accordingly held that courts must calculate pre-tax profitability before deducting any taxes, regardless whether they are U.S. or foreign. Compaq, 277 F.3d at 784-785; see also IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001).

As the Fifth and Eighth Circuits explained, this rule follows from the "venerable principle, articulated in Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929)," that "'[t]he discharge by a third person of [a taxpayer's] obligation'" is "'equivalent to receipt by the person taxed.'" Compaq, 277 F.3d at 784; see also IES, 253 F.3d at 354. In Old Colony, the Supreme Court held that when an employer withholds an employee's taxes, the employee's income is the gross amount, not reduced by the taxes paid. 279 U.S. at 729. The same principle applies to foreign taxes: When a taxpayer earns income subject to a foreign tax, "the economic benefit to [the taxpayer] [is] the amount of . . . gross [income], before the foreign taxes [are] paid." IES Indus., 253 F.3d at 354; see also Compaq, 277 F.3d at 784. The situation is "no different from an employer withholding and paying to the government income taxes for an employee: the full amount before taxes are paid is considered income to the employee." IES Indus., 253 F.3d at 354; see also Compaq, 277 F.3d at 784-785; Santander, 977 F. Supp. 2d at 52-53. BNY's prospective profit thus should have included all its income from the transaction, not reduced by its U.K. tax.

The Tax Court brushed off Compaq and IES, stating that it was "not bound by Fifth and Eighth Circuit precedent" and speculating that this Court might take a different view. SPA32 n.9. But the Tax Court's explanations for doing so lack merit. First, the court posited that "[e]conomically, foreign taxes are the same as any other transaction cost" and should be treated as such in the pre-tax profitability analysis. Id. But that sweeps away the central premise that foreign tax payments are to be credited. Moreover, under Old Colony, domestic taxes indisputably do not reduce a taxpayer's income for purposes of determining profitability, and there is no basis for treating foreign taxes differently.

The Tax Court also thought it would "undermine the point of the economic substance doctrine" to "exclud[e] the economic effect of foreign taxes from the pre-tax analysis." SPA32-33 n.9.20 But it makes no sense to ignore U.S. tax benefits while counting foreign tax liabilities, or to evaluate the profitability of foreign transactions after deducting foreign tax while evaluating domestic transactions as if they were tax-free. The Tax Court's approach effectively required BNY to prove the STARS transaction would be profitable even if taxed twice. As other courts have recognized, that approach unfairly stacks the deck against taxpayers who make foreign investments and subverts Congress's purpose to facilitate transactions that would otherwise make no economic sense in the face of double taxation. See Compaq, 277 F.3d at 785.

2. The Tax Court compounded this error by excluding from the profitability analysis the income BNY earned on the Trust assets. SPA35-36. This error independently requires reversal; when combined with the erroneous treatment of BNY's U.K. taxes, it renders the court's decision logically indefensible. The court effectively treated the Trust assets as if they yielded no income, while saddling BNY with the costs of the U.K. tax incurred on that very income.

The court reasoned that, as a matter of law, "[e]conomic benefits that would result independent of a transaction do not constitute a non-tax benefit for purposes of testing its economic substance." SPA35. Applying that rule, the court deemed BNY's Trust income irrelevant because the assets would have generated the same income regardless whether they were placed in the Trust. As the Tax Court's lone citation makes clear, however, this holding lacks support. Id.21

Courts reject the view that the economic-substance analysis must disregard any income that is not incremental. In Cottage Savings Association v. Commissioner, 499 U.S. 554, 557 (1991), the Supreme Court considered a taxpayer's exchange of one pool of depreciated mortgages for a "substantially identical" pool. Although the economic value of the taxpayer's holdings was essentially unchanged, the Court rejected the Sixth Circuit's holding that the transaction lacked economic substance. Id. at 567-568. Similarly, in Kraft Foods Co. v. Commissioner, 232 F.2d 118 (2d Cir. 1956), this Court considered whether the taxpayer could deduct interest paid on debentures it issued to its parent as a dividend. The transaction yielded no incremental profit, but simply converted a portion of the parent's equity to debt in response to a change in the tax law. The IRS argued that the debt instruments "simply represented the originally-invested equity capital in a new dress," id. at 126, but the Court rejected the IRS's economic-substance challenge, id. at 128; see also UPS v. Commissioner, 254 F.3d 1014, 1020 (11th Cir. 2001) (rejecting economic-substance challenge where business "continued to operate after its reconfiguration much as before," reasoning that "the [Internal Revenue] Code treats lots of categories of economically similar behavior differently").

Here, the STARS transaction allowed BNY to "employ [its] [assets] in the most remunerative way possible," Frank Lyon, 435 U.S. at 575, by using them to obtain a favorable loan that reduced the interest costs of its banking business and lent stability to its funding sources, supra pp. 7, 8-9. No authority supports subjecting BNY to double taxation merely because it did not have to change its assets' management or operation materially to achieve those benefits.

When combined, these two errors -- counting foreign taxes as costs, yet ignoring the non-incremental income that generated those taxes -- pose an even greater threat to the purposes of the foreign tax credit. Suppose a U.S. citizen owns a U.S. business that generates a pre-tax profit of $9 million per year. He determines that moving the business to the United Kingdom would decrease his costs by $1 million and thereby increase his pre-tax profits to $10 million a year. Because the United States taxes worldwide income, the owner would continue to owe U.S. taxes, but would also incur U.K. taxes of $3 million (assuming a 30% U.K. income tax rate). Under Compaq and IES, the owner could claim foreign tax credits for his U.K. tax, leaving his worldwide tax bill unchanged (except to the extent he pays additional U.S. tax on his increased profits).

The Tax Court, in contrast, would count the $3 million U.K. tax against the move's profitability, but ignore all the taxpayer's income except the $1 million incremental gain, thereby treating the owner's decision to move the business as if it resulted in a $2 million loss. As a result, the court would find the move objectively unprofitable and disallow the foreign tax credit. Indeed, whenever the increase in profit between a domestic transaction and a foreign transaction is less than the anticipated tax in the foreign country, the foreign transaction would always be "unprofitable" under the Tax Court's approach.

The Tax Court's rule would thus treat a broad range of ordinary business transactions as lacking in economic substance. Disallowing the foreign tax credit in these circumstances would make double taxation commonplace and discourage companies from engaging in international transactions -- precisely the opposite of the result Congress intended in enacting the foreign tax credit.

B. The Court Erred In Disregarding BNY's Profit From The Spread

BNY expected to earn significant net interest income from the STARS transaction because its interest costs for obtaining the loan were offset by the spread. Supra p. 11. In the Tax Court's view, however, the spread was not a "commercially reasonable" "component of . . . interest" on the loan, but instead a "tax effect" that improperly reflected Barclays's U.K. tax benefits. SPA42, SPA45. The court therefore ignored the spread and evaluated BNY's prospects for profit as if BNY had paid a higher hypothetical interest rate. SPA41-46. This analysis is contrary to precedent and to the facts of the transaction.

A court applying the economic-substance doctrine must "'fix[ ] the character of the proceeding by what actually occurred.'" Gilbert v. Commissioner, 248 F.2d 399, 403 (2d Cir. 1957) (quoting Gregory v. Helvering, 293 U.S. 465, 469 (1935)); see also ACM P'ship v. Commissioner, 157 F.3d 231, 250 (3d Cir. 1998). Courts "cannot manufacture facts that never occurred to create an otherwise non-existent tax liability." Greene v. United States, 13 F.3d 577, 583 (2d Cir. 1994) (applying step-transaction doctrine). Here, whether or not the interest rate as reduced by the spread was commercially "typical" or "reasonable" in the IRS's opinion, it was the actual rate that governed the flow of funds between the parties, JA3541-3542, and the court was obligated to consider the actual terms on which BNY engaged in the transaction.

The Tax Court apparently viewed the discounted interest rate as illegitimate because it was better than what BNY could have obtained in a typical loan. But that was precisely the point: Barclays offered the favorable rate to make the transaction attractive to BNY. JA3130. Even if the Tax Court were correct that the spread was too good to be a "commercially reasonable" "component of interest," that characterization does not alter the economic-substance analysis. Barclays undertook a private obligation, following arm's-length negotiations, to offset BNY's interest costs by the spread. BNY expected to and did receive an economic benefit from that discount. The value of that benefit to BNY does not depend on Barclays's reason for providing it. Indeed, even under the Tax Court's erroneous view that the loan should be disregarded entirely in the economic-substance analysis, infra Section II.C, BNY received an economic benefit from that transfer of value simply by participating in the Trust. Cf. Santander, 977 F. Supp. 2d at 49 n.3. The law required the court to consider that benefit as BNY actually received it.

The Tax Court held, however, that the economic benefit BNY derived from the spread must be disregarded as a "tax effect" because it reflected Barclays's U.K. tax benefits. SPA43-44. That was error. First, as the Santander court explained, "[t]he terms 'taxes' and 'tax credits' are properly understood to refer to transactions between a taxpayer and a taxing authority, not transactions between private parties, even if the 'effect' is to lessen for a taxpayer the economic burden of having paid the tax." 977 F. Supp. 2d at 51. Here, the spread was neither a tax nor any other form of payment to or from a taxing authority, but a private obligation negotiated between private parties.22

Moreover, the fact that Barclays gained a U.K. tax advantage and took that tax advantage into account in offering the favorable interest rate does not justify the Tax Court's disregard of the economic value BNY derived from the spread.

Courts "cannot ignore the reality that the tax laws affect the shape of nearly every business transaction." Frank Lyon, 435 U.S. at 580. The Supreme Court has thus rejected the Tax Court's reasoning, holding that "[t]he fact that favorable tax consequences were taken into account" by parties to a transaction "is no reason for disallowing those consequences." Id. That holding applies with particular force here, where the "tax effect" the Tax Court sought to remove from the transaction's pricing was a tax benefit under foreign law to a foreign counterparty whose tax position is not at issue. The validity of BNY's tax reporting under U.S. law does not, and should not, depend on the motives of an unrelated foreign counterparty under the tax laws of its own country. See Dolan, The Foreign Tax Credit Diaries -- Litigation Run Amok, 140 Tax Notes 895, 901 (2013); Cummings, The Economic Substance Doctrine as Penalty, 138 Tax Notes 1465, 1470 (2013).

The Tax Court's contrary approach has no limit or justification, would prove unworkable in practice, and would produce absurd results. Suppose a U.S. bank provides a high-interest-rate loan to a U.K. manufacturer that receives green-energy tax credits under U.K. law to produce solar panels. This transaction plainly has economic substance for the U.S. bank. But under the Tax Court's approach, if the IRS could link the manufacturer's willingness to pay the high rate to its U.K. tax benefits, the court would disregard the U.S. bank's actual profit as a "tax effect." Similarly, when one party to a transaction comes out in a better tax position than the other, parties commonly adjust the price to account for the disparity. Doing so does not deprive the transaction of economic substance. The Tax Court, however, would treat that privately negotiated price adjustment as a "tax effect" to be ignored in testing the transaction for economic substance.

Thus, under the Tax Court's rule, U.S. taxpayers could face double taxation whenever a foreign counterparty offers favorable terms that relate to the counterparty's tax position under foreign law. To avoid that result, the U.S. taxpayer would have to look behind the terms of every foreign transaction to determine whether the terms were shaped by the foreign country's tax treatment of the counterparty. If they were, the taxpayer would have to either forgo the transaction or take the risk that the benefit it expected to receive could be disregarded as a "tax effect." That result would impose an immense burden on international transactions, contrary to the purpose of the foreign tax credit.

C. The Court Erred By Ignoring The $1.5 Billion Loan And The Return BNY Expected To Earn By Investing The Loan Proceeds

Finally, the Tax Court decided to ignore the loan and consider only the Trust in its profitability analysis. It further held that, even when viewed as a whole, the transaction presented no opportunity for profit because the return BNY expected to earn by investing the loan proceeds could not be counted. Again, the court erred.

1. As noted, "a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred." Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148 (1974). "[T]he transaction[ ] must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant." IES, 253 F.3d at 356 (quoting Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945)) (first alteration in original).

What "actually occurred" here is clear. BNY and Barclays negotiated STARS as one integrated transaction that was consummated in a single closing and defined in a single set of contracts. Both banks' witnesses testified without contradiction that BNY would not have participated in the Trust without the loan and that Barclays would not have offered the favorable loan without the Trust. JA93, JA246, JA556; supra p. 7. Indeed, Barclays could not have achieved its U.K. tax objectives unless the transaction qualified as part of its "financial trade," and the loan served to ensure that tax treatment. Supra p. 15; JA454-455. The parties' negotiating positions as to the Trust and the loan were also interrelated: BNY wanted to maximize the size of the loan at a low interest rate while minimizing the assets it placed into the Trust; Barclays wanted a smaller loan at a higher rate and more assets in the Trust. JA112-113, JA206, JA217-218, JA269, JA288, JA300, JA369, JA691. The final terms of the transaction reflected an arm's-length compromise of these considerations.

The transaction also operated on an integrated basis. Trust assets served as collateral for the loan while generating the income that gave Barclays its U.K. tax benefits, in turn enabling Barclays to offer the discounted interest rate. Supra pp. 5-15. Barclays made the loan by purchasing Trust units. BNY paid a component of its monthly interest obligations through distributions to Barclays on the Class D unit. SPA14-15; JA3576. And BNY repaid the principal by purchasing Barclays's Trust units. See supra pp. 10, 12-13.

The Tax Court nonetheless decided to excise the loan from the transaction and ignore its economic benefits to BNY, reasoning -- without regard to the U.K. "financial trade" requirement, supra p. 15 -- that "the loan was not necessary for the STARS structure to produce the disputed foreign tax credits." SPA31. The court accordingly considered the economic substance of only the Trust in isolation. Id. No authority supports this approach. The Tax Court cited a handful of decisions, SPA30-31, but in none of them did the courts artificially subdivide a single, integrated transaction into disaggregated pieces. For example, in Sala v. United States, 613 F.3d 1249, 1252-1253 (10th Cir. 2010), the court disregarded aspects of a transaction that "ha[d] no connection whatsoever" to the aspect that produced the challenged tax benefit; there was "a clear break between each phase," and the challenged portion "[could not] be legitimized merely because [it was] on the periphery of some legitimate transactions." Id. at 1252. Similarly, in ACM Partnership, the court focused on one component of a transaction that was "executed independently of, did not further, and in fact impeded" the taxpayer's asserted nontax objectives. 157 F.3d at 256 & n.48. And in Long Term Capital Holdings v. United States, the district court rejected the taxpayer's argument that two transactions should be considered together where "there was nothing inherent in the transactions that required them to be viewed as one" and "not even [the taxpayer] really regarded the two as unitary." 330 F. Supp. 2d 122, 184 (D. Conn. 2004), aff'd, 150 F. App'x 40 (2d Cir. 2005).

Here, in contrast, both parties indisputably understood the STARS transaction to be unitary. The parties did not simply staple a loan onto the transaction as an afterthought to disguise some tax motivation on BNY's part for participating in the Trust. To the contrary, BNY had no incentive to participate in the Trust absent the profit it expected to earn by borrowing $1.5 billion at the favorable rate -- reduced by the spread -- and lending or investing the proceeds at a higher rate, and Barclays would not have offered the loan on bargain terms without the Trust. Supra pp. 5-15. The court thus had no authority to "'slic[e] and dic[e]' . . . [the] integrated transaction solely because the Government aggressively ch[ose] to challenge only an isolated component." Shell Petroleum v. United States, 2008 WL 2714252, at *35 (S.D. Tex. July 3, 2008).

Relying on the IRS's experts, the Tax Court speculated that the loan could be severed from the Trust because "Barclays could have made the same $1.5 billion loan to BNY, secured by the same assets . . . using only a loan agreement and a security agreement." SPA39. But it would have been nonsensical for Barclays to offer the same loan at the same interest rate without the Trust, because it was the U.K. tax treatment of the Trust structure that made the favorable rate viable for Barclays. And even if Barclays might somehow have felt moved to lend BNY the money without any corresponding benefit to itself, that possibility is legally irrelevant: The Tax Court should have considered the transaction as the parties envisioned and executed it, not as the court and the IRS's experts speculate (baselessly) that it could have occurred. In any event, even viewing the Trust in isolation, the transaction had economic substance in light of the value BNY derived from the spread as revenue for participating in the Trust. Supra pp. 11, 46-47.

2. Even when evaluating the Trust and the loan together "as an integrated transaction," the Tax Court held that "[o]nly cashflows arising from the transaction whose economic substance is at issue are relevant to the pre-tax profitability analysis." SPA48. Concluding that "[a]ny income from investing the loan proceeds" resulted from "separate and distinct" investment activity, the court excluded BNY's expected return on the loan proceeds from the profitability analysis. SPA49; see SPA50-51.

Contrary to the Tax Court's ruling, courts applying the economic-substance doctrine to financing transactions regularly consider the use to which the taxpayer intends to put the proceeds of the financing. In Goldstein, for example, this Court compared the taxpayer's loan costs with her expected return on investing the loan proceeds. See 364 F.2d at 739; see also Shirar v. Commissioner, 916 F.2d 1414, 1418 (9th Cir. 1990) (comparing cost of loan to taxpayer's return on investment); Hines v. United States, 912 F.2d 736, 738-740, (4th Cir. 1990) (comparing cost of financing to purchase equipment against expected revenues from leasing equipment). At a minimum, even if "future profits [that] hinge on future taxpayer action that seriously departs from past conduct" are not relevant, courts should consider profits resulting from taxpayer action that is "consistent with the taxpayer's actual past conduct." Dow Chem. Co. v. United States, 435 F.3d 594, 601 (6th Cir. 2006) (discussing Knetsch, 364 U.S. at 361-366); see also Northern Indiana Pub. Serv. Co. v. Commissioner, 115 F.3d 506, 512-513 (7th Cir. 1997) (transaction would be respected for tax purposes where corporation earned profit on the difference between the interest rate it charged to a borrower and the rate it paid to obtain funding); Bankman, The Economic Substance Doctrine, 74 S. Cal. L. Rev. 5, 22-23 (2000) ("financing is naturally linked to the use of proceeds from the financing, and . . . the latter provides sufficient business purpose").

When a commercial bank borrows money, there is nothing "separate" or "distinct" about investing those funds in the ordinary course of its banking business. Such investments are the "bread and butter" of what banks do. JA132. Here, the evidence demonstrates that BNY entered into the STARS transaction to secure low-interest funding to use in its banking business. The Tax Court even found that "the loan proceeds were available . . . to use in [BNY's] banking business throughout the STARS transaction," and thus that the "loan served a purpose beyond the creation of tax benefits." SPA66.

In contrast, none of the cases cited by the Tax Court involved investment income that flowed directly from the transaction to be tested. See, e.g., Nicole Rose, 320 F.3d at 283-284 (excluding gains from unrelated asset sale in profitability analysis of lease restructuring); ACM P'ship, 157 F.3d at 160 n.57 (excluding income from investment of assets that "were not involved" in the transaction at issue); Long Term Capital, 330 F. Supp. 2d at 183 (excluding income from investment the taxpayer treated as unrelated to transactions at issue).

Under the Tax Court's approach, few financing transactions could satisfy the economic-substance test. Suppose a taxpayer borrows $1,000 at 5% to fund a subsequent investment the taxpayer projects will earn a 10% return. The Tax Court's analysis of the borrowing transaction would exclude the potential profits from the investment, thus leaving the taxpayer with only the obligation to repay the principal and interest and disregarding the upside of the financing. The court would accordingly ignore the transaction for tax purposes, disregarding the taxpayer's judgment as to what loan terms best serve its business purposes. Like the rest of the court's analysis, that theory makes no sense and should be rejected.

 

* * *

 

 

By permitting double taxation of BNY's income from a transaction that promised significant profit and no reduction in BNY's global tax, the Tax Court's decision stretches the economic-substance doctrine far beyond the "cautious approach" this Court has long endorsed. Nassau Lens, 308 F.2d at 45. The Tax Court ignored the terms of the transaction as BNY actually understood and engaged in it and unfairly predetermined a holding of no economic substance in a transaction that was replete with it. This Court should reject that use of the economic-substance doctrine. Congress and the Treasury Department are free to amend the rules that govern the foreign tax credit, and indeed they have done so. But the Court should not permit the IRS to wield the economic-substance doctrine as a retroactive "trump card" to invalidate otherwise valid foreign tax credits that arose from a transaction that exemplified BNY's substantive business activity as a commercial bank. Santander, 977 F. Supp. 2d at 49-50.

 

CONCLUSION

 

 

The judgment should be reversed.
Respectfully submitted.

 

 

William J. Perlstein

 

Alan E. Schoenfeld

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

7 World Trade Center

 

250 Greenwich Street

 

New York, NY 10007

 

(212) 230-8800

 

 

Roger M. Ritt

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

60 State Street

 

Boston, MA 02109

 

(617) 526-6000

 

 

Seth P. Waxman

 

Catherine M.A. Carroll

 

Weili J. Shaw

 

Jonathan A. Bressler

 

Wilmer Cutler Pickering

 

Hale And Dorr LLP

 

1875 Pennsylvania Avenue, NW

 

Washington, DC 20006

 

(202) 663-6000

 

June 12, 2014

 

FOOTNOTES

 

 

1 BNY's appeal encompasses the Tax Court's holdings disallowing BNY's deduction of transaction expenses and adjusting BNY's foreign-source income, which followed from the court's economic-substance determination. SPA52-54.

2 This case involves the tax liabilities of The Bank of New York Company, Inc., which merged with Mellon Financial Corporation in 2007 to form The Bank of New York Mellon Corporation. JA3512, JA3600-3602. The Bank of New York Company was the parent of a group of entities that filed consolidated federal tax returns. JA3512. "BNY" refers to that group.

3 Barclays initially proposed a rate of 281 basis points (2.81%) below the one-month London Inter-Bank Offered Rate ("LIBOR"), a common interest-rate benchmark. JA91, JA113, JA1237.

4 The transaction comprised numerous contracts between Barclays and various BNY subsidiaries, which the parties negotiated as a package and executed together. JA3513-3514. For simplicity, this brief explains the ultimate effect of the transaction on Barclays and the BNY corporate group.

5 As the Tax Court described, BNY funded and managed the Trust through an existing subsidiary and several newly created entities. See SPA6-10. Barclays required the use of these entities so that the Trust would qualify for U.K. tax purposes as a type of "collective investment scheme," or "CIS," which is a defined investment vehicle under U.K. law. JA431-432, JA445-446, JA2761-2762. As occurred in this case, a CIS may take the form of an "unauthorized unit trust," in which assets are held in trust for unitholders. The designation "unauthorized" simply means the trust is not authorized to be promoted for sale to the public. JA233-234, JA430-432, JA434, JA439, JA449, JA2750-2756, JA2793.

6 Barclays also received monthly distributions as holder of the Class D unit, totaling about $6.75 million over the transaction's five-year term. JA3525-3526, JA3576. Barclays purchased the Class D unit free of the blocked account to ensure that Barclays would qualify for its desired U.K. tax treatment as a participant in a CIS, supra n.5; JA247, JA442.

7 One month after the transaction closed, the parties entered into an agreement to accelerate the benefits of STARS without altering its structure. Under this "stripping transaction," BNY contributed additional funds to the Trust in exchange for certain assets, effectively converting the Trust's right to future cash-flows on those assets into an up-front payment. JA180, JA300, JA3560-3568. Because the amount of that payment was taxable immediately under U.K. law (rather than over time, as under U.S. law), a portion of Barclays's expected U.K. tax benefits -- and, with them, the spread -- was concentrated at the beginning of the transaction's five-year term. JA126, JA180, JA300, JA319-320, JA3568.

8 For simplicity, this "$100" example takes account only of the distributions due on Barclays's Class C unit, ignoring the one percent of Trust income payable to BNY on the Class A unit, the small amounts payable to Barclays on the Class D unit, and other expenses. Supra pp. 10-11 & n.6.

9 This $15.40 translated into a pre-tax equivalent of $22 per $100 of Trust income. JA245-246. As noted, the parties set the amount of the spread -- i.e., the amount by which Barclays agreed to reduce BNY's monthly interest costs -- as half the expected pre-tax value of Barclays's U.K. tax benefits, or $11 per $100 of Trust income. Supra p. 11; JA245-246. That $11 was also deductible as part of Barclays's financial trade. SPA21; JA246, JA464.

10 In years when LIBOR was low enough that the negotiated interest rate resulted in a net payment by Barclays to BNY, supra p. 11, BNY reduced its deductions for unrelated interest expense (thereby increasing its taxable income) by the amount of the payment. JA3582.

11 Based on its economic-substance determination, the Tax Court further held that BNY could not deduct certain transaction expenses and that BNY's income on the Trust assets should not have been categorized as foreign-source income. SPA52-54.

On BNY's motion for reconsideration, the court clarified certain consequences of its analysis. First, because the court had severed the loan from the Trust and held only the latter to lack economic substance, the court held that the loan itself served a purpose beyond the creation of tax benefits and that BNY could therefore deduct interest on the loan at a LIBOR-based rate that disregarded the spread. SPA63-67. Additionally, based on its characterization of the spread as a tax effect, the court held that BNY's income attributable to the spread should not be included in BNY's taxable income, SPA67-69, and that other interest expense deductions should not have been disallowed, SPA69-70. The Commissioner has cross-appealed these rulings. JA11-12.

12 In Article 23(1) of the 1980 U.S.-U.K. tax treaty, the United States agreed to credit income taxes paid to the United Kingdom on income subject to U.K. tax.

13 When codifying a statutory version of the economic-substance doctrine in 2010 -- applicable only prospectively -- Congress recognized that the economic substance test does not necessarily apply to all transactions. See 26 U.S.C. § 7701(o)(5)(C) ("whether the economic substance doctrine is relevant to a transaction" shall be determined "in the same manner as if this subsection had never been enacted"); H.R. Rep. No. 111-443(I), at 296 & n.124 (2010) ("If the tax benefits are clearly consistent with all applicable provisions of the Code and the purposes of such provisions, it is not intended that such tax benefits be disallowed if the only reason for such disallowance is that the transaction fails the economic substance doctrine as defined in this provision.").

14See Santander, 977 F. Supp. 2d 46 (rejecting economic-substance challenge to a STARS transaction); Salem Fin., Inc. v. United States, 112 Fed. Cl. 543 (2013) (upholding economic-substance challenge to a STARS transaction), appeal docketed, No. 14-5027 (Fed. Cir. Dec. 12, 2013); Wells Fargo & Co. v. United States, 2013 WL 6017366 (D. Minn. Oct. 28, 2013) (special master's report) (discussing economic-substance challenge to a STARS transaction).

15See Compaq Computer Corp. v. Commissioner, 113 T.C. 214 (1999), rev'd, 277 F.3d 778 (5th Cir. 2001); IES Indus., Inc. v. United States, 1999 WL 973538 (N.D. Iowa Sept. 22, 1999), rev'd, 253 F.3d 350 (8th Cir. 2001). In Pritired 1, LLC v. United States, 816 F. Supp. 2d 693, 735-741 (S.D. Iowa 2011), the district court examined a cross-border financing transaction under the economic-substance doctrine and invalidated the U.S. taxpayer's foreign tax credits, but the claimed credits were not otherwise valid. See id. at 730, 732-735; see also Hewlett-Packard Co. v. Commissioner, T.C. Memo 2012-135, at *1-2, 19-31 & n.29 (disallowing foreign tax credits on other grounds and declining to consider IRS's economic-substance challenge).

In American International Group, Inc. v. United States, No. 14-765 (2d Cir. docketed Mar. 17, 2014), appellant AIG has noted its intent to argue that the economic-substance doctrine cannot be applied to disallow foreign tax credits that comply with all statutory and regulatory requirements. If the Court were to agree, that decision would apply here.

16 The Tax Court cited no evidence that BNY had any subjective motive except to earn net interest income. The court relied solely on the testimony of the IRS's experts, who deemed the STARS transaction commercially "unreasonable" compared to a traditional loan. SPA36-40, SPA41-47. The court erred in relying on that testimony. Post hoc expert analysis bears no relevance to BNY's subjective motivation for entering into the transaction. See, e.g., Lippe v. Bairnco Corp., 288 B.R. 678, 688 (S.D.N.Y. 2003) (Chin, J.), aff'd, 99 F. App'x 274 (2d Cir. 2004).

17 BNY's expert calculated expected net interest income at the time of closing of roughly $455 million, representing the difference between the expected return on BNY's investment of the loan proceeds and the cost of the loan to BNY as reduced by the spread. The expert also calculated that BNY could have expected over $1.2 billion in income on the Trust assets over the life of the transaction, as well as expenses of approximately $65 million. JA3003. The Tax Court rejected this analysis not because it found the expert's calculations factually incorrect, but because it disagreed as a legal matter with the expert's decisions to include each of these terms in the profitability analysis. See SPA47-50; infra Part II.

18 The IRS has not disputed that the transaction qualified for foreign tax credits under the rules as they existed at the time BNY undertook the transaction. In 2007 -- after the transaction terminated -- the IRS drafted regulations to amend the foreign tax credit rules to preclude credits for certain transactions similar to STARS. See 72 Fed. Reg. 15,081, 15,084 (Mar. 30, 2007) ("recogniz[ing] that there is often a business purpose" for the targeted transactions, but proposing to exclude them from the foreign tax credit due to the resulting "reduction in [U.S.] tax payments"). A temporary version of the regulations took effect in 2008, and the IRS adopted final rules in 2011. See 76 Fed. Reg. 42,036 (July 18, 2011) (promulgating 26 C.F.R. § 1.901-2(e)(5)(iv)).

19 The Tax Court's decision should be reversed as a matter of law. See Frank Lyon, 435 U.S. at 581 n.16. As noted, some decisions of this Court describe the question whether a transaction lacks economic substance as an issue of fact reviewable for clear error. Supra pp. 20-21. Those decisions conflict with Supreme Court precedent, precedent of other circuits, and other decisions of this Court. Id. The inconsistency is irrelevant, however, because the pertinent historical facts here are undisputed, and the Tax Court clearly erred in finding no economic substance on those facts. The court also made numerous legal errors, discussed in Part II, that require reversal as a matter of law.

20 The court cited In re CM Holdings, Inc., 301 F.3d 96, 105 (3d Cir. 2002), but in that case, the Third Circuit rejected a request to modify its profitability analysis to account for tax effects, holding that the analysis must consider "the actual cash flows of [the] investment."

21 The court cited only its decision in Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. 67 (2012), which in turn cites nothing. Id. at 174.

22 The Santander court also addressed a related argument the government pressed there and in the Tax Court here -- namely, that the spread must be disregarded as an "effective rebate" of BNY's U.K. tax. The Tax Court did not adopt that argument in this case, and the Santander court rejected it as "wholly unconvincing." 977 F. Supp. 2d at 50. Among other things, the Tax Code and regulations contain detailed rules for determining when a foreign government has "rebate[d]" or "subsid[ized]" taxes paid, supra p. 25, and the IRS has never contended that the spread fell within those provisions. The IRS's position also contradicts the long-established principle -- codified in the technical taxpayer rule, supra pp. 24-25 -- that the foreign tax credit turns on legal liability for foreign tax, not the tax's economic burden. Biddle, 302 U.S. at 580-581; 26 C.F.R. § 1.901-2(f).

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Case Name
    THE BANK OF NEW YORK MELLON CORPORATION, AS SUCCESSOR IN INTEREST TO THE BANK OF NEW YORK COMPANY, INC., Petitioner-Appellant/Cross-Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee/Cross-Appellant.
  • Court
    United States Court of Appeals for the Second Circuit
  • Docket
    Nos. 14-704, 14-1394
  • Authors
    Waxman, Seth P.
  • Institutional Authors
    Wilmer Cutler Pickering Hale and Dorr LLP
  • Cross-Reference
    Appealing Bank of New York Mellon Corp. v. Commissioner, 140

    T.C. 15 (2013) 2013 TNT 29-8: Court Opinions.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2014-15130
  • Tax Analysts Electronic Citation
    2014 TNT 117-17
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