Corporation Asks Supreme Court to Review Economic Substance Test

In this case, the First Circuit held that, under the economic substance test, a court should treat a U.S. taxpayer's foreign tax payments (but not its domestic U.S. tax payments) as "expenses" in assessing whether a transaction possesses a reasonable probability of pre-tax profit. Such an approach means that a transaction could pass the test if conducted within the U.S. (because domestic tax payments are not treated as "expenses") but could fail the test if conducted on a cross-border basis (because foreign tax payments, treated as expenses, would count against the profitability of the transaction). The First Circuit followed a rule established by the Federal and Second Circuits, in conflict with decisions in the Fifth and Eighth Circuits.

The Question Presented is:

Whether foreign tax payments should be treated as "expenses" and thereby factored into a court's pre-tax profitability calculation under the economic substance test.

                           TABLE OF CONTENTS

The IRS has followed such a strategy here. Despite Sovereign's compliance with all applicable statutory and regulatory provisions, the IRS disallowed Sovereign's tax credit, asserting that the cross-border transaction that gave rise to the U.K. tax liability lacked "economic substance." The district court rejected the assessment and ordered a refund, but the First Circuit reversed the district court, allowing the Government to disallow Sovereign's FTCs, thereby requiring Sovereign to pay both U.K. and U.S. taxes on the same income -- in clear violation of Congress' decision to establish FTCs to prevent double taxation.

The First Circuit's analysis is as troubling as the result. The court applied an amorphous legal standard "centered on" determining whether the transaction "was merely a device to avoid tax liability" -- notwithstanding that "it actually occurred and technically complied with the tax code." Pet. App. 14a. It concluded that Sovereign's cross-border transaction was such "a device" because it was "profitless." Id. at 16a. It was "profitless," however, only because the court included the foreign taxes Sovereign paid as an expense of the transaction and excluded the FTCs it sought from the transaction's revenue. In other words, rather than evenhandedly counting either all tax effects or no tax effects in assessing whether the transaction had profit independent of its tax effects, the First Circuit selectively counted some tax effects: foreign taxes paid but not the credits earned by paying those same taxes. That methodology conflicts with decisions in the Fifth and Eighth Circuit in Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001), and IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001). It also stacks the deck against finding a transaction profitable and directly affects the viability of a wide range of international transactions by U.S. companies.

The First Circuit's holding deepens a circuit conflict involving five courts of appeals. The First Circuit followed earlier decisions of the Federal Circuit and Second Circuit in holding that foreign tax payments are expenses when assessing the profitability of a transaction under the economic substance doctrine. Salem Financial, Inc. v. United States, 786 F.3d 932, 946-949 (Fed. Cir. 2015); Bank of New York Mellon Corp. v. Comm'r, 801 F.3d 104,118, 124 (2d Cir. 2015). These courts specifically acknowledged that their holdings conflicted with the earlier decisions of the Fifth and Eighth Circuits in Compaq and IES. Although this Court denied review in Salem Financial, No. 15-380, and Bank of New York Mellon Corp., No. 15-572 (cert. denied Mar. 7, 2016), this case presents a better vehicle than the previous petitions, and the Government's prior reasons for denying scrutiny have been invalidated by subsequent developments.

The contrast between the First Circuit's decision in this case and Summa Holdings, Inc. v. Comm'r of Internal Revenue, 16-1712, 2017 WL 631663 (6th Cir. Feb. 16, 2017), demonstrates that the circuit split is fundamental and entrenched. It reflects broader disagreement among the appellate courts about the meaning and application of so-called anti-abuse doctrines and the role of the federal courts in promulgating judge-made law under a detailed statutory scheme. "If the government can undo transactions that the terms of the Code expressly authorize, it's fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is." Summa Holdings, Inc., 2017 WL 631663, at *1. This Court's plenary review is amply warranted.

A. The Statutory Scheme of Foreign Tax Credits Under Section 901 of the Internal Revenue Code.

The United States taxes U.S. taxpayers' worldwide income, including foreign-source income that is also taxed by a foreign country. 26 U.S.C. § 61(a). Absent some offsetting tax credit, a U.S. taxpayer earning income overseas would pay tax on that income twice -- once to the foreign country, and once to the United States. PPL Corp. v. Commissioner, 133 S. Ct. 1897, 1901 n.2 (2013). Recognizing that "double taxation" discourages international commerce, Congress enacted the foreign tax credit ("FTC") in 1918. As this Court has recognized, the "primary design" of the 1918 foreign tax credit "was to mitigate the evil of double taxation." The FTC prevents double taxation by authorizing U.S. taxpayers to take a dollar-for-dollar credit offsetting their U.S. income taxes by amounts paid as income tax to a foreign country on foreign-source income. 26 U.S.C. § 901(b) (Pet. App. 61a-63a); see also id. § 27(a).

The claiming of FTCs is the subject of extensive and detailed government regulation. Statutes and regulations prescribe that foreign tax credits are available only in carefully delineated circumstances and only up to designated limits. Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 15.21[1] [a] (7th ed. Supp. 2014); see 26 U.S.C. § 904(a). The statutory and regulatory provisions create a highly-reticulated regime that is exceedingly complicated, but necessary to encourage economically desirable cross-border investment.

B. Factual Background Of This Case.

Sovereign was a U.S.-based commercial bank that entered into a transaction known as a Structured Trust Advantaged Repackaged Securities ("STARS") with U.K.-based Barclays Bank. Pet. App. 7a. STARS included a loan from Barclays to Sovereign. Barclays designed STARS so that the loan also created tax benefits for Barclays under U.K. law.

The key aspects of STARS were as follows:

Sovereign contributed approximately $6.7 billion of income-producing assets to a Trust with a U.K.-based trustee, roughly $1.3 billion of which served as collateral for the loan. Id. The Trust's income was subject to U.K. income tax, which Sovereign paid, through the Trust. Pet. Id. At the same time, Sovereign reported the Trust's income on its U.S. federal income tax return (as required), and claimed U.S. foreign tax credits in the amount of the tax payments remitted by the Trust to the U.K. government. Sovereign's entitlement to these U.S. foreign tax credits is at issue in this case. Id.

Barclays made the loan to Sovereign by acquiring an interest in the Trust for $750 million at the Trust's inception, and acquiring an additional $400 million interest one year later. Sovereign was required to repay the $1.15 billion in five years. Pet. App. 7a-8a. Sovereign made interest payments to Barclays on the $1.15 billion. Pet. App. 8a. At the same time, Barclays set off Sovereign's interest payment against a separate payment from Barclays to Sovereign called the "Bx" or "Barclays Payment." Id. The amount of the Bx was based on Barclays' expected U.K. tax credits, which are described below. Pet. App. 9a.

The Trust was subject to a 22% U.K. tax on its income, which Sovereign, as the owner of the Trust assets, paid. Separately, Barclays ownership interest in the Trust subjected it to U.K. tax at a rate of 30% on income distributed from the Trust to it. The U.K., however, permitted Barclays to take a 22% credit to avoid being taxed on the Trust income twice, reducing Barclays's net tax liability to 8% of the Trust's distributable income. Pet. App. 9a. If the Trust earned $100, for example, Barclays would owe $8 in U.K. tax absent any other benefits.

The transaction afforded Barclays additional U.K. tax benefits in the form of a deduction that eliminated its 8% tax liability and generated a net U.K. tax benefit. This tax benefit arose from Barclays receipt of monthly distributions from the Trust, which it recontributed back to the Trust (as required by the transaction documents). Pet. App. 9a. Using as an example $100 of Trust income distributed to Barclays, Barclays contributed back to the Trust $78.² It was entitled to a 30% deduction for the amount it contributed to the Trust, or $23.40. This deduction more than offset Barclays' $8 U.K. tax liability, yielding a net after-tax benefit of $15.40. Pet. App. 9a-10a. U.K. law also allowed Barclays to deduct the Bx payment to Sovereign, for an additional benefit to Barclays of $3.30. Pet. App. 10a.

By engaging in the STARS transaction, Sovereign transferred some of its income tax liability from the United States to the United Kingdom. It secured a loan of $1.15 billion and it was paid the Bx, which effectively reduced its lending costs. Barclays, in turn, secured U.K. tax benefits it could use to offset income unrelated to the transaction.

C. The District Court Proceedings

In 2009, the IRS issued a Notice of Deficiency, disallowing Sovereign's foreign tax credits.³ The IRS did not challenge Sovereign's compliance with the statutory and regulatory requirements governing the foreign tax credit, asserting instead that the STARS transaction lacked "economic substance." Pet. App. 28a.

Sovereign paid the assessment and sued for a refund in the United States District Court for the District of Massachusetts. Although STARS was structured as a single, integrated financing transaction, the Government argued it should be bifurcated into separate trust and loan transactions. Though Sovereign disagreed with that characterization, it accepted a bifurcated treatment for purposes of summary judgment and appeal. Pet. App. 6a n.4, 28a n.3. This petition addresses the decision regarding the economic substance of the trust.

In January 2016, the district court entered a final judgment in favor of Sovereign. The judgment arose from two separate orders, each rejecting different Government arguments as to why the Trust component of the STARS transaction was profitless and therefore lacked economic substance. Pet. App. 24a, 41a.⁴

In support of its motion for summary judgment, the Government argued the transaction lacked economic substance because it was profitless, and it was profitless because the U.K. tax paid by Sovereign should be considered a pre-tax expense of the transaction, rather than a "tax," while the U.S. foreign tax credit it received should be considered a "tax" rather than revenue. Pet. App. 45a-49a. Tellingly, however, the Government's own experts did not treat foreign tax as an expense when calculating the pre-tax profit of the transaction. CA1 JA75-76. In fact, one of the Government's experts admitted that the pre-tax profit test should not include foreign taxes. CA1 JA84.

The district court rejected the Government's summary judgment argument as "circular" and a "bootstrap position" that "assumes what it seeks to prove: the foreign tax credit should be ignored for purposes of the profitability analysis." Pet. App. 48a-49a. Relying on Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 785 (5th Cir. 2001), the district court held that "to be consistent" the economic substance analysis "should either count all tax effects or not count any of them." "To do otherwise 'is to stack the deck against finding the transaction profitable.'" Pet. App. 48a (quoting Compaq, 277 F.3d at 785).

Looking through the government's persistent "rhetorical flourishes" and "undertone of indignation," the district court concluded that "[w]hat seems to bother the government is not so much that Sovereign does not qualify for foreign tax credits as that it does not deserve them." Pet. App. 47a, 58a-59a. By turning Sovereign's entitlement to tax credits into "as much a matter of moral judgment as legal," the government ran a "serious risk" of creating a legal standard that "becomes a kind of smell test, with the judge's nose ending up the crucial determinant of the outcome." Id. at 58a-59a.

Here, the district court concluded, the government's argument for disallowing Sovereign's FTCs was "visceral" rather than "analytical." Pet. App. 59a. According to the district court, the IRS took an approach that was "fanciful," and "ma[d]e no sense," aside from its "utility for the particular case at hand." Id. at 53a, 59a. Ultimately, for the district court, this case "illustrate[d]" that "the judicial anti-abuse doctrines -- whether substance over form or economic substance -- can themselves be susceptible to abuse." Id. at 57a. "The characterization the government uses to condemn Sovereign's actions in the STARS transaction is not limited to the STARS transaction." Id. at 54a. Rejecting the government's argument as based on "novel principles of judgment," the court granted summary judgment for Sovereign. Id. at 59a.

D. The Decision Below.

The First Circuit, exercising de novo review, Pet. App. 15a, reversed. The Court of Appeals began by opining that "the economic substance test guards against abuse of loopholes that Congress and the IRS have not anticipated." Pet. App. 11a n.7. The First Circuit opined that "when the challenged transaction has no prospect for pre-tax profit[,] then it is an act of tax evasion that, even if technically compliant, lies outside of the intent of the Tax Code and so lacks economic substance." Id. at 15a.

The First Circuit treated the economic substance test as authorizing a court to decide for itself whether a transaction is "merely a device to avoid tax liability." Pet. App. 14a. The Court of Appeals accepted the Government's contention that Sovereign's U.K. tax payments should be "factored into the pre-tax profitability calculation." Pet. App. 17a. It then concluded that the "Trust transaction is plainly profitless" because "[w]hen the U.K. taxes are recognized as expenses, there is no pre-tax profit. . . ." Id. at 17a n.11.

The court stated that its decision to treat Sovereign's foreign tax payments as transaction expenses "mirrors that of the Federal Circuit" in Salem Financial v. United States, 736 F.3d 932 (Fed. Cir. 2015). Pet. App. 16a. The court acknowledged contrary holdings from the Fifth and Eighth Circuits in Compaq Computer, 277 F.3d at 785 and IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir.2001), which had, in turn, relied on this Court's decision in Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) for the conclusion that foreign tax payments should not be considered pre-tax expenses. Pet. App. 17a n.11.

The court chose to follow the Federal Circuit over the Fifth and Eighth Circuits because "[ Compaq and IES ] did not analyze STARS transactions and so are distinguishable factually." Id. And "Old Colony did not involve foreign taxes and says nothing about whether foreign tax liability may ever be considered an expense." Id.

Second, this Court's review is warranted because the circuit conflict arises out of a broader disagreement among the lower courts regarding the underlying premises of the economic substance doctrine.

This hybrid approach, in which foreign taxes count, but U.S. credits do not, is directly opposed to decisions by the Fifth and Eighth Circuits, which held that neither foreign taxes nor resulting U.S. credits should be taken into account when assessing a transaction's profitability. See also Bank of N.Y. Mellon, 801 F.3d 124 ("[W]e agree with the Federal Circuit in Salem and disagree with decisions of the Fifth and Eighth Circuits (Compaq and IES, respectively.)"; Pet. App. 17a n.11 ("Sovereign and the district court rely heavily on Compaq and IES for the proposition that foreign taxes should not be treated as expenses. . . . We agree with the Salem court's analysis of this issue as to the Trust transaction.") (citing Salem Financial, 786 F.3d at 947-49).

In the transactions at issue in Compaq and IES, U.S. companies bought shares in Dutch companies just before the dividend record date (purchasing stock that was pregnant with immediately forthcoming dividends), collected the dividend, and then immediately sold the shares at a loss. The companies claimed foreign tax credits for taxes they paid to the Netherlands to offset their U.S. tax on the dividend income, and used the loss on the sale of shares to offset unrelated capital gains. See Compaq, 277 F.3d at 779-780; IES, 253 F.3d at 352.

On appeal, both the Fifth and Eighth Circuits held that the gross dividend, not the dividend net of foreign taxes, should have been used to determine whether the transaction was profitable. ("Because the entire amount of the . . . dividends was income to IES, the . . . transactions resulted in a profit, an economic benefit to IES."); Compaq, 277 F.3d at 786. As the Fifth Circuit explained: if the tax had been paid to the United States rather than the Netherlands, "there would have been no argument that [the gross amount] was not income to [the taxpayer]"; and it was "irrelevant" "[t]hat the tax was imposed by the Netherlands rather than by the United States." Compaq, 277 F.3d at 783-784. The Eighth Circuit employed similar reasoning. "Pre-tax income is pre-tax income regardless of the . . . origin of the tax." Id. at 784. 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, 253 F.3d at 354. That 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." Id. (citing Old Colony Trust Co., 279 U.S. at 729).

In Compaq, the Fifth Circuit criticized the IRS's approach -- the same approach the First Circuit adopted here. The Fifth Circuit noted that "counsel for the Government admitted that he had found no case supporting the proposition that foreign tax on a transaction should be treated as an expense." 277 F.3d at 785 n.7. The Fifth Circuit took issue with the IRS for "treat[ing] the [foreign] tax as a cost of the transaction, but . . . not treat[ing] the corresponding U.S. tax credit as a benefit of the transaction." Id. at 782. That "half pre-tax, half after-tax calculation" of profit was an unfair and "curious method of calculation." By "count[ing]" taxes "only when they subtract from cash flow," the IRS "stack[s] the deck against finding the transaction profitable." Id. at 785. "To be consistent," the court explained, "the analysis should either count all tax law effects or not count any of them." Id.

In this case, the First Circuit followed the approach the Fifth and Eighth Circuits rejected. It concluded the transaction lacked potential for profit because "every $1 the Trust transaction earns through the Bx payment costs $2 from the transaction costs of subjecting the Trust transaction to U.K. tax." Pet. App. 17a. Under the holdings in Compaq and IES, the foreign taxes paid to the U.K. would not be considered in the profitability calculation. The First Circuit's assertion that Compaq and IES "did not analyze STARS transactions and so are distinguishable factually," Pet. App. 17a n.11, simply does not address the Fifth Circuit's cogent criticism that the First Circuit's approach "stacks the deck against finding the transaction profitable." Compaq, 277 F.3d at 785.

Moreover, the First Circuit's adoption of the Federal Circuit's reasoning (see Pet. App. 17a n.11 ("We agree with the Salem court's analysis of this issue as to the trust transaction.")) undermines any suggestion that the different outcomes arise from different facts: the Federal Circuit concluded not that Compaq and IES were distinguishable, but that they were wrongly decided because they failed to treat foreign taxes as expenses. The Federal Circuit opined that "[t]he Compaq and IES transactions produced no real economic profit." Salem, 786 F.3d at 948. The Federal Circuit emphasized that any apparent profit in those cases was a result of including in income the amount of the dividend "without taking into account the foreign taxes paid on the dividend." Id.

In short, the transactions in Compaq and IES would have been decided differently had they arisen in the First, Second, or Federal Circuits. And, conversely, if this case had arisen in the Fifth or Eighth Circuits, the foreign tax expense incurred by Sovereign would have been excluded from the calculation of the transaction's profit, and the trust transaction would have been deemed to generate substantial pre-tax profit. It is intolerable for the availability of federal tax credits to turn on the fortuity of the circuit in which the taxpayer resides. This Court should grant certiorari and resolve this circuit split.

A. The Circuit Split On Foreign Tax Treatment Reflects Broader Uncertainty About Core Questions Underlying the Anti-Abuse Doctrines.

One leading tax treatise aptly describes the economic substance doctrine as "exquisitely uncertain." Bittker & Lokken, Federal Taxation of Income, Estates, and Gifts ¶ 4.3.1 & n.8 (2013). Another commentator explains that it is "applied differently from circuit to circuit and sometimes inconsistently within circuits." Modern Tax Controversies, 957 Practicing Law Inst. at 478-35 (2012). A tax court judge concurs, explaining that a "free-standing approach to identifying economic substance, . . . empower[s] the courts (or the Commissioner) to tailor the statute to unforeseen circumstances." James S. Halpern, Putting The Cart Before The Horse: Determining Economic Substance Independent Of The Language Of The Code, 2010 VA. TAX. REV. 327, 337-38. Even the Treasury Department has recognized these concerns. It reported that the economic substance and related anti-abuse doctrines are "inherently subjective," that "courts have applied them unevenly," and that "a great deal of uncertainty exists as to when and to what extent these standards apply, how they apply, and how taxpayers may rebut their assertions." Department of the Treasury, The Problem of Corporate Tax Shelters: Discussion, Analysis, and Legislative Proposals 94 (July 1999).

The lower courts have expressed similar views. The Second Circuit has opined that "[t]he law of economic substance, it must be said, is not a model of clarity." United States v. Coplan, 703 F.3d 46, 91 (2d Cir. 2012). The Sixth Circuit (per Sutton, J.) recently explained that the confusion arises because "the line" the anti-abuse doctrines attempt to demarcate "between disregarding a too-clever-by-half accounting trick and nullifying a Code-supported tax-minimizing transaction can be elusive." Summa Holdings, Inc. v. Comm'r of Internal Revenue, No.16-1712, 2017 WL 631663, at *5 (6th Cir. Feb. 16, 2017). The doctrine's "elusive[ness]" has led to fundamental disagreements among the circuits.

The three appellate courts that have adjudicated economic substance challenges to STARS transactions have applied the economic substance doctrine as a stand-alone requirement that must be satisfied independent of -- and in addition to -- any requirements imposed by the Internal Revenue Code. As the Federal Circuit explained in Salem Financial, "'economic substance is a prerequisite to the application of any Code provision allowing deductions.'" 786 F.3d at 941 (quoting Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006)). The Second Circuit, disallowing FTCs in Bank of New York Mellon, took the same approach."The economic substance doctrine exists to provide courts a 'second look' to ensure that particular uses of tax benefits comply with Congress's purpose in creating that benefit." Bank of N.Y. Mellon, 801 F.3d at 113.

In the decision below, the First Circuit adopted the Federal Circuit's approach to evaluating economic substance. Pet. App. 6a. Notwithstanding the First Circuit's pro forma assertion that the economic substance doctrine should effectuate legislative intent, Pet. App. 8a, the court never examined any of the specific statutory or regulatory provisions implicated by STARS. Instead, like the Federal Circuit and Second Circuit, the First Circuit devoted its analysis to the nebulous task of "'assess[ing] the transaction's economic reality.'" Pet. App. 16a. (quoting Salem Financial, 786 F.3d at 948).⁵

A recent decision by the Sixth Circuit, however, joined an earlier D.C. Circuit decision in rejecting this approach. In Summa Holdings, Inc. v. Comm'r, 2017 WL 631663, the court explained that the economic substance doctrine is neither a "prerequisite" nor a judicial "second look" that can be applied independent of the Code. "It's one thing to permit the Commissioner to recharacterize the economic substance of a transaction -- to honor the fiscal realities of what taxpayers have done over the form in which they have done it. But it's quite another to permit the Commissioner to recharacterize the meaning of statutes -- to ignore their form, their words, in favor of his perception of their substance." Id. at *3.

In Summa Holdings Inc., the government relied on the "substance-over-form" doctrine to recharacterize a company's commission payments to its subsidiary as dividends to its shareholders, resulting in an unpaid income tax liability. 2017 WL 631663, at *3. The Tax Court upheld the assessment, but the Sixth Circuit reversed. It concluded that the transaction complied with the statutory requirements and was consistent with their purpose. Id. at *6. Consequently, the government lacked authority to recharacterize the transaction in the guise of "effectuating" the underlying purpose of the Code.

The Sixth Circuit's understanding of the economic substance doctrine as a tool of statutory construction is shared by the D.C. Circuit. In Horn v. C.I.R., 968 F.2d 1229 (D.C. Cir. 1992), the D.C. Circuit held that losses incurred by taxpayers in connection with straddle transactions were allowed under the Tax Reform Act of 1984, reversing the Tax Court's decision that the transactions in which the taxpayers engaged were "economic shams." The D.C. Circuit opined that:

The First Circuit's formulation of the "sham transaction" doctrine is thus inconsistent with the approaches of both the Sixth Circuit and the D.C. Circuit.

Those courts that apply the economic substance doctrine as a self-standing common law rule have created a fact-based legal standard directed at discerning the "practical economic effects" of the transaction. James v. Comm'r, 899 F.2d 905, 908-09 (10th Cir. 1990). This is an unbounded and amorphous analysis, the goal of which is to ascertain whether the transaction "lack[ed] economic reality." Coltec Indus., Inc., 454 F.3d at 1355. The transaction's objective profitability and the taxpayer's purpose are merely factors, among others, in a wide-ranging inquiry. See ACM P'ship v. Comm'r, 157 F.3d 231, 247 (3d Cir. 1998) (objective effect and subjective purpose of the transaction "do not constitute discrete prongs of a rigid two-step analysis, but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes."); Bank of N.Y. Mellon, 801 F.3d at 115 ("we employ a 'flexible' analysis where both prongs are factors to consider in the overall inquiry into a transaction's practical economic effects").

By contrast, the Sixth and D.C. Circuits apply a text-bound analysis, consistent with other canons of statutory construction, to discern economic substance. As Judge Sutton explained: "If the government can [under the economic substance doctrine] undo transactions that the terms of the Code expressly authorize, it's fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is." Summa Holdings, Inc., 2017 WL 631663, at *1. Thus, the Sixth Circuit, applying the doctrine as a tool of statutory construction, does not seek the inchoate "economic reality" of a transaction, or attempt to divine the "'overarching' purpose of the Code." Id. at *7. Rather, recognizing that "purpose must be grounded in text," id., the Sixth Circuit looks to the purpose behind the specific provisions of the Code that the government seeks to override.

In Summa, for example, the Sixth Circuit recognized that the function of the specific code provisions in question was to "enable tax savings," and it rejected the government's attempt to "place ad hoc limits on them by invoking a statutory purpose . . . that has little relevance to the text-driven function of these portions of the Code. . . ." Id. Similarly, the D.C. Circuit in Horn reversed a Tax Court decision disallowing deductions under the sham transaction doctrine, and explained that the transaction's validity did not turn on its "practical economic effects," but rather on its consistency with the statute under which it was permitted. "[W]hile following the parties' assumptions that the transactions at issue here were not entered into for economic profit and that no evidence has shown a nontax business purpose, we analyze section 108 to see whether it nonetheless authorizes the claimed deductions." Horn, 968 F.2d at 1238. The court concluded that the specific statutory provision at issue reflected Congress's intent to permit transactions like the one at issue. Id.

Thus, the different legal standards applied by the circuits have outcome-determinative effects.

Defending its characterization of the foreign tax payment as an expense, the court stated:

A textual approach, incorporating the "subtleties" and "discrete rules" of the FTC at the appropriate granular level shows that the factors on which the court relied when characterizing the foreign tax payment as an expense -- that Barclays bore the burden of Sovereign's U.K. tax, and that Barclays was able to secure U.K. tax benefits by doing so -- are consistent with, indeed contemplated by the FTC regime. Summa Holdings, Inc., 2017 WL 631663, at *7. They therefore cannot, consistent with legislative intent, preclude Sovereign's entitlement to those credits.

First, the foreign tax credit regime contains a specific rule that the identity of the party bearing the economic burden of a foreign tax is not relevant to determining who is entitled to the FTC. The "technical taxpayer" rule gives the FTC to the taxpayer legally liable for the tax, rather than the party that paid it. "Tax is considered paid by the taxpayer even if another party to a direct or indirect transaction with the taxpayer agrees, as a part of the transaction, to assume the taxpayer's foreign tax liability." Treas. Reg. § 1.901-2(f)(2)(i) (Pet. App. 36a, 96a-98a); see also James M. Peaslee, Economic Substance Test Abused: Notice 98-5 and the Foreign Law Taxpayer Rule, Special Report, Tax Notes (TA), 79, 101 (Apr. 6, 1998) ("[T]he section 901 regulations and case law establish unambiguously that bearing the burden of a tax is neither a necessary nor sufficient condition for claiming a credit."); Shannon Weeks McCormack, Tax Shelters And Statutory Interpretation: A Much Needed Purposive Approach, 3 UNIV. OF ILL. L. REV. 697, 765 (2009) ("When one looks at the foreign tax credit regime, it is by no means clear . . . that there is a purpose to restrict foreign tax credits to taxpayers who have economically borne them."). Thus, one core fact on which the First Circuit relied to conclude that the payment of foreign taxes was a transaction expense, and therefore disallow FTCs, is a fact that the FTC regime expressly contemplates, directing that a party is still entitled to FTCs for foreign taxes even if it does not bear the economic burden of that tax.

Similarly, in finding Sovereign's foreign tax payments to be a transaction expense, the First Circuit gave substantial weight to Barclays's ability to "claim substantial U.K. tax benefits for itself," Pet. App. 19a (quoting Salem Financial, 786 F.3d at 952). But that fact, too, is contemplated and addressed by the statutory and regulatory scheme. Section 901(i), 26 U.S.C. § 901(i) (Pet. App. 30a, 67a) and Treasury Regulation 1.901-2(e) (Pet. App. 81a), codify the "subsidy rule," which explains exactly when tax benefits provided by a foreign government will preclude a taxpayer from seeking FTCs. The government conceded that the "subsidy rule" did not apply in this case; that is, it acknowledged that the tax benefits Barclays secured did not impact Sovereign's entitlement to FTCs under the statutory provision directly addressing the issue. Pet. App. 32a; Weeks, supra, at 769 (arguing that using economic substance doctrine to "look at other cash flows of the deal to see if the foreign tax was recouped anywhere within the transaction" is "not rooted in the purposes of the law").

The First Circuit undermined its position by pointing to an IRS regulation proposed in 2007 and finalized in 2011 prohibiting STARS transactions, but not retroactively. Pet. App. 3a. The very existence of that prospective-only regulation is telling. The First Circuit construed the judge-made economic substance doctrine to reach the same result on a retroactive basis, even though the regulation expressly did not apply to the transaction in this case. The regulation demonstrates the impropriety of stretching the economic substance doctrine, because the IRS already possesses ample rulemaking authority in this area.⁷

Thus, the circuit split on the treatment of foreign taxes arises from deeper conflicts over the nature and scope of judicial anti-abuse doctrines. In this case, the First Circuit's nontextual approach converted the economic substance doctrine into "a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take." Summa Holdings, Inc., 2017 WL 631663, at *8. A textually grounded approach, by contrast, recognizes that "the best way to effectuate Congress's nuanced policy judgments is to apply each provision as its text requires -- not to elevate purpose over text when taxpayers structure their transactions in unanticipated tax-reducing ways." Id. at *7.

The circuit split on the treatment of foreign expenses is one symptom of a deeper and broader conflict over the nature and purpose of judicial anti-abuse doctrines.

B. Divergent Applications Of Anti-Abuse Doctrines Among The Circuits Undermines Certainty In The Tax Law.

This Court has long recognized the particular need for uniformity in the administration of the federal tax system. See, e.g., Aquilino v. United States, 363 U.S. 509, 514 (1960); Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 543 (1979)("[T]ax law . . . can give no quarter to uncertainty."). In advocating for grants of certiorari, the Solicitor General has likewise underscored the "significant governmental and public interest in the uniform administration of federal tax law." U.S. Br. 20, Beard v. Commissioner, No. 10-1553 (July 2011) (recommending certiorari); see also U.S. Br. 14, PPL Corp. v. Commissioner, No. 12-43 (Sept. 2012) (recommending certiorari where circuit conflict "implicate[d] the important federal interest in uniform enforcement of the federal tax laws"). Without this Court's intervention, "inequalities in the administration of the revenue laws" will persist. Commissioner v. Sunnen, 333 U.S. 591, 599 (1948).

These disparities are important because the First Circuit's rule would use the economic substance doctrine to negate rather than promote congressional intent. Treating foreign taxes as pre-tax "expenses" runs afoul of the fundamental purpose underlying the FTC regime -- i.e., that foreign taxes and U.S. taxes should be treated the same for U.S. tax purposes, so that taxpayers are indifferent as to which they incur. Congress enacted the FTC to "encourage[ ] foreign investment abroad" by ensuring that "a dollar anywhere should be subject to the same tax." S. Rep. No. 86-1393, at 24 (1960). The FTC statute "in effect treat[s] the taxes imposed by the foreign country as if they were imposed by the United States." H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 76 (1954). As the Government acknowledged below, the FTC represents Congress' effort to "neutralize the effect of U.S. taxes on decisions where to invest or conduct business most productively." CA1 Govt. Br. 29. But the First Circuit's approach would frustrate Congress' decision to create parity between U.S. and foreign taxes so far as the U.S. income tax laws are concerned. Under the First Circuit's rule, the same transaction might be deemed "profitable" if conducted domestically, but "unprofitable" if undertaken on a cross-border basis, because in the latter situation foreign taxes would be treated as an "expense." This is the opposite of what Congress intended.

Uniform application of Congress' FTC scheme has important implications because the foreign tax credit "is the largest tax credit claimed by corporations," accounting for more than $100 billion in tax credits annually. Luttrell, IRS Statistics of Income Bulletin, Corporate Foreign Tax Credit, 2010, at 1 (Fall 2014). Corporations across all economic sectors claimed foreign tax credits "tall[ying] 75.5 percent of all U.S. income tax before credits and 62.5 percent of U.S. income tax after credits." Id. at 2. The circuit splits at issue here thus undermines uniformity in one of the most significant areas of tax law.

As the briefs of numerous amici in the First Circuit explained, "[p]redictability and certainty are especially critical in the application of the FTC, whose core purpose is to encourage cross-border commerce. When companies consider cross-border investment and business activity, tax implications are a critical consideration." Br. of Amicus Curiae Financial Services Roundtable at 16, No. 16-1282 (1st Cir.); see also Br. of Amicus Curiae Chamber of Commerce of the United States at 1, 5-9, No. 16-1282 (1st Cir.) (explaining reliance of broad swath of business community on predictable application of FTC rules); Br. of Amicus Curiae Atlantic Legal Foundation at 32-33, No. 16-1282 (1st Cir.) (emphasizing taxpayers' need to minimize uncertainty in cross border transactions).

These decisions should not dissuade the Court from granting review in this case. First, this case is a better vehicle than Nos. 15-380 and 15-572 because this petition presents the circuit split as part of the broader disagreement among the circuits as to the purpose and elements of judicial anti-abuse doctrines. The petitions in Nos. 15-380 and 15-572 addressed the application of the economic substance doctrine to foreign tax credits. Thus, the Question Presented in No. 15-572 began: "This petition concerns the application of the economic substance doctrine to foreign tax credits petitioner claimed for foreign taxes it paid on a multi-billion-dollar cross-border transaction." Pet. in No. 15-572, at i. The Question Presented in No. 15-380 similarly stated that "[t]his case involves the denial of a foreign tax credit for hundreds of millions of dollars in taxes." Pet. in No. 15-380, at i. The instant petition would allow the Court to address the broader principles discussed in the Sixth Circuit's recent decision in Summa Holdings, Inc. v. Comm'r of Internal Revenue, No. 16-1712, 2017 WL 631663 (6th Cir. Feb. 16, 2017), which makes clear that the circuit conflict is much more fundamental.

Next, the Government's arguments for denial of review in Nos. 15-380 and 15-572 have not withstood the test of time. In 2016, the Government told this Court that the Federal Circuit's decision in Salem Financial "lack[ed] prospective importance." BIO in No. 15-380, at *12 (filed Jan. 4, 2016). But that forecast has been disproven. In this very case, the First Circuit followed the Federal Circuit's decision in Salem Financial.

Next, in 2016 the Government counseled this Court that review was unnecessary because the Federal Circuit's decision in Salem Financial did not depend on whether foreign taxes were treated as pre-tax expenses (the issue on which the Fifth and Eighth Circuit had ruled in Compaq and IES). According to the Government, the Federal Circuit in Salem Financial "did not rest its economic-substance determination on the fact that the STARS transaction was unprofitable after foreign taxes were paid." Id. at *14. Yet the First Circuit has now taken the opposite view of the Federal Circuit's decision in Salem Financial. The First Circuit explained -- contrary to the Government's argument to this Court in 2016 -- that the very basis of the economic substance determination is the fact that the STARS transaction was unprofitable after foreign taxes were paid. Pet. App. 16a-17a. In 2016, the Government told this Court that application of the economic substance test did not depend on the treatment of foreign taxes as expenses. In contrast, the First Circuit rested its decision on its determination that "the U.K. taxes . . . are factored into the pre-tax profitability calculation" under the economic substance test. Id.

Further, in 2016 the Government urged this Court to deny review in light of 2010 federal legislation providing that "tax benefits . . . with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose." 26 U.S.C. § 7701(o)(5)(A). See BIO in No. 15-380, at 18-19; BIO in No. 572, at 25-26. But nothing in the 2010 legislation resolves the circuit split at issue here regarding the purpose of the economic substance doctrine and its elements. The 2010 legislation codifies pre-existing "common law doctrine." Id. at § 7701(o)(5)(A). It prescribes that "[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted." Id. § 7701(o)(5)(C). As directed by Congress, the IRS thus continues to apply pre-codification economic substance case law. See IRS Notice 2010-62, at 4 (Oct. 4, 2010) ("The IRS will continue to rely on relevant case law under the common-law economic substance doctrine in applying . . . section 7701(o)(1)."). Thus, the 2010 legislation does not obviate the need for this Court's review.

Indeed, if anything, the 2010 legislation heightens the need for this Court's review. With respect to the treatment of foreign tax payments in particular, Congress in 2010 rejected a House Ways and Means proposal to make foreign taxes an expense categorically, in assessing the economic substance of cross-border transactions.⁸ In other words, Congress rejected the rule adopted by the First Circuit in this case. Instead, Congress directed the Secretary of the Treasury to "issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases." 26 U.S.C. § 7701(o)(2)(B) (emphasis added). Seven years later, Treasury has issued no such regulation, and courts continue to apply inconsistent rules. The First Circuit improperly stepped into the breach by adopting via judicial fiat a rule that Congress declined to enact and that the Treasury Department has declined to promulgate through notice-and-comment rulemaking.

Respectfully submitted,

² The other $22 was income tax retained by the U.K.

³ The IRS also disallowed deductions for the loan interest Sovereign paid to Barclays. The district court held that the loan component of the STARS transaction had economic substance -- "it was a real loan," Pet. App. 45a -- so Sovereign was entitled to a refund of the loan interest deduction disallowed by the Government. The Government did not appeal the district court's conclusion that loan interest was deductible. Sovereign's entitlement to refund of its loan interest deduction is no longer at issue. Pet. App. 6a n.4.

⁴ In an October 2013 order granting Sovereign partial summary judgment, the district court rejected the government's argument that the Bx payment was a "tax effect" rather than income. The First Circuit did not address this question and it is not at issue in this petition. This petition addresses the First Circuit's reversal of the district court's November 2015 order granting summary judgment to Sovereign.

⁵ The Eleventh Circuit also follows this approach, treating judicial anti-abuse doctrines as an overlay on the Code. "The analysis of whether something is a sham, then, must occur before analysis of the [statutory provisions]." Kirchman v. Comm'r, 862 F.2d 1486, 1491 (11th Cir. 1989).

⁶ The court in Horn identified cases from five circuits, which had held that the economic substance doctrine must be satisfied in addition to the statutory requirements of the Code. 968 F.2d at 1238 n.12 (identifying disagreement with Lerman v. Comm'r, 939 F.2d 44, 52 (3d Cir. 1991) (holding that "economic substance is a prerequisite to the application of any Code provisions"); Friedman v. Comm'r, 869 F.2d 785, 791 (4th Cir. 1989) (holding statutory provision is "inapplicable to this case because the transactions at issue constitute economic shams"); United States v. Atkins, 869 F.2d 135, 139 (2d Cir. 1989) (declining to apply statutory criteria to "sham transactions"); Kirchman v. Comm'r, 862 F.2d 1486, 1491 (11th Cir. 1989) ("The analysis of whether something is a sham, then, must occur before analysis of the [statutory criteria]"); Sochin v. Comm'r, 843 F.2d 351, 353 n.6 (9th Cir. 1988) (applying bifurcated standard where court must first "determine[ ] that the transaction is itself bona fide, i.e. that it is not a sham" and only then apply the statutory criteria).

⁷ An administrative regulation promulgated by an expert agency enjoys many advantages over a judge-made rule, as the district court noted in this case. Pet. App. 35a ("If there were to be such a new principle adopted, and it would be a new principle, it would be better done through the legislative and rulemaking processes where the focus is broad, rather than through adjudication where the focus is particular and possibly outcome-driven."). The regulation cited by the First Circuit is an intricate measure, with detailed rules and twelve examples illustrating its operations. A court could not decree anything resembling such a rule.

⁸ The House Ways and Means Committee adopted a bill that would have expressly overruled Compaq and IES, stating that "foreign taxes shall be taken into account as expenses in determining pre-tax profit." H. Conf. Rept. No. 111-299 at 61 (2009) (proposed section 452(o)(2)(B)). But this language was omitted from the final statute, which instead directed the Treasury to "issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases." 26 U.S.C. § 7701(o)(2)(B) (emphasis added). Notably, in its contemporaneous report on the enactment of Section 7701(o), the Joint Committee on Taxation cited Compaq and IES without suggesting that either was no longer good law. Staff of the J. Comm. on Tax'n, 111th Cong., 2d Sess., Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010," as Amended, in Combination with the "Patient Protection and Affordable Care Act," 143 n.305, 145 n.312, 155 n.356 (JCX-18-10) (Comm. Print Mar. 21, 2010).