Government Argues AIG Transactions Lacked Economic Substance

Congress never intended to allow taxpayers to enjoy such tax benefits, derived entirely from tax-driven and economically empty activity. For that reason, the courts have applied common law doctrines, including the economic substance doctrine, to prevent clever taxpayers from designing sham transactions that comply with the letter of the written law, but do nothing more than generate tax benefits that Congress never intended. That is exactly what AIG has done in the transactions at issue here.

As the district court (Louis L. Stanton, J.) correctly held, there are genuine disputes of material fact regarding the propriety of AIG's transactions, and a trial is therefore necessary to determine if AIG can meet its burden of demonstrating that the transactions had economic substance. That is a fact-intensive question, and the record now before the Court on this interlocutory appeal is far short of complete, as expert discovery has not even commenced. Nevertheless, even the incomplete record demonstrates that AIG entered into the transactions not for a legitimate business purpose, but solely to generate excess foreign tax credits, and that the transactions, viewed objectively, have no economic basis absent the tax benefits that they generated for AIG.

Faced with these facts, AIG argues that that the economic substance doctrine does not apply at all to transactions involving foreign tax credits -- an argument that contradicts the legislative intent of the foreign tax credit regime and disregards decades of precedent. Alternatively, AIG contends that its transactions, as a matter of law, have economic substance. But this Court's cases provide that a court conducting an economic substance analysis looks to both the taxpayer's subjective business purpose in entering into the transactions and the objective economic effects of the transactions -- and on both questions, there are genuine disputes of material fact. The district court's denial of summary judgment was therefore correct, and should be affirmed.

2. Whether there is a genuine dispute of material fact as to whether AIG's transactions lacked economic substance.

On February 27, 2009, AIG filed this action challenging the IRS's disallowance of foreign tax credits for the 1997 tax year in connection with six "borrowing" transactions and one "investment" transaction, and seeking a refund of over $306,000,000. (JA 19-70). The government asserted defenses based on the economic substance, the substance-over-form, and the step transaction doctrines. (JA 269). AIG eventually amended its complaint (JA 4907-59), and the government reasserted the same defenses (JA 4995-96).

On July 30, 2010, in the midst of fact discovery, AIG moved for partial summary judgment with respect to all seven transactions, contending they had economic substance (but not addressing the substance-over-form or step-transaction doctrines). (JA 336, 339-86). On March 29, 2011, the district court denied AIG's motion without prejudice, concluding that the government had demonstrated the need for additional discovery. (JA 4881).

On August 1, 2012, after the close of fact discovery but before the commencement of expert discovery, AIG renewed its motion for partial summary judgment, limited to the six "borrowing" transactions. (JA 5010-11, 5018).¹ Once again, AIG did not address either the substance-over-form or step-transaction doctrines. (JA 5013-18). The government again opposed AIG's motion, both on substantive grounds and based on the need for additional discovery. (JA 5082-5133, 6004-06).

On March 29, 2013, the district court denied AIG's motion. (Special Appendix ("SPA") 1-16). On November 5, 2013, the district court granted AIG's motion for certification of the order for interlocutory appeal pursuant to 28 U.S.C. § 1292(b). (SPA 17-23). On November 15, 2013, AIG petitioned this Court for leave to appeal the order, which this Court granted on March 17, 2014. (JA 6183-208, 6236).

B. The "Borrowing" Transactions

The basic structure of each transaction was the same. (SPA 2; Brief for Plaintiff-Appellant ("Br.") 8-9).³ AIG-FP funded a foreign-domiciled special purpose vehicle ("SPV") in return for preferred and common shares of the SPV. (SPA 2; JA 389-90, 2355; Br. 8). The foreign bank supplied a substantial majority, though not all, of the capital for the SPV through a purchase of SPV preferred stock from AIG-FP. (JA 391-92, 394-95, 398, 403, 405, 408, 2362). AIG-FP agreed to repurchase the preferred stock on a future date at the original sale price in order to claim the transaction was a collateralized loan for U.S. tax purposes, while simultaneously allowing its counter-party to claim ownership of the stock for foreign tax purposes. (SPA 3, 13, 15-16; JA 392, 395-96, 398-400, 402-03, 405-06, 408-09, 2355-56; Br. 9). The SPV used the combined funds to purchase a portfolio of debt securities and entered into agreements with AIG-FP to produce a fixed return in the SPV from which fixed payments were paid to the foreign bank in the form of dividends. (SPA 2; JA 392, 395-96, 399-400, 404, 407, 409-10, 2355; Br. 8-9). AIG-FP carefully controlled the cash flows in the SPV so that they were only enough to pay the SPV's operating expenses, foreign income taxes, and predetermined dividends on the shares held by the foreign bank. (JA 2361-62, 2838-39, 2939, 3762, 3927).

Although AIG-FP was ostensibly also entitled to dividends on its common shares, it designed the transaction such that its dividends would be nominal at best (JA 2460-61, 2470, 2829-30), and indeed AIG-FP was "indifferent" to whether it ever received such dividends (JA 2462). In fact, during the life of some of the "borrowing" transactions, AIG-FP had to infuse the relevant SPV with additional capital because the SPV was unable to cover its costs and foreign taxes, and could not pay the dividends owed to the foreign bank, let alone generate any residual return for AIG. (JA 2454-55, 2358-62, 2473, 2614-15, 2830, 3117-20, 3940, 4031-35).

For U.S. tax purposes, AIG claimed that it owned all of the shares of the SPVs, including the preferred shares held in form by the foreign bank, and treated the foreign banks' funds as loans to AIG. (SPA 3, 13, 15-16; JA 392, 395-96, 398-400, 402-03, 405-06, 408-09, 2355-56, 3928-29; Br. 9). AIG reported the dividends paid to the foreign banks by the SPVs as if the dividends were paid first to AIG and then paid to the banks as tax-deductible interest expenses. (Id.; JA 2239-43, 3761-62, 3972, 4634).

The SPVs paid substantially all of their after-tax cash as dividends to the foreign banks. (JA 2362). Because the economic income of the SPV was paid to the foreign bank, AIG did not receive any meaningful cash return on its purported investment in the SPV; instead, AIG derived "profit" from the transactions in the form of foreign tax credits. (JA 2322, 2353-62, 2365-66, 2511, 2518, 2522, 3189-98, 3930-33, 3758-67, 3769-72, 3776-77, 3945, 3949, 3953, 4043, 4061, 4099-100, 4103, 4428-29, 4634). In addition, AIG deducted on its U.S. tax returns virtually all of the SPV's after-tax income that was paid to the foreign bank as interest expense. (JA 393-94, 397, 401, 404-05, 407-08, 410, 2239-43, 3761-62, 3972, 4634). AIG was then able to use the foreign tax credits to reduce U.S. tax on unrelated income. (Id.).

Each foreign bank, in contrast, reported to the relevant foreign revenue authority that it owned the SPV preferred stock. (SPA 3; JA 393-94, 397, 401, 404-05, 407-08, 410, 3051-53; Br. 9). Under the relevant foreign law, this allowed the foreign bank to report the distributions from the SPV as tax-exempt dividends rather than as taxable interest on the loan to AIG. (Id.). The structure effectively shifted the liability for the foreign tax on the interest income from the foreign bank to the SPV, and converted interest expense that AIG would otherwise pay into foreign tax payments by the SPV for which AIG claimed foreign tax credits. (JA 2321, 2325, 2353-62, 2875, 2893-95, 3100, 3196, 3758-67, 3769-72, 3776-77, 3749, 3945, 3949, 3953, 4025-29, 4634). Once the taxes had been shifted to the SPV, AIG could use the foreign tax credits to reduce U.S. tax on its unrelated income, and pay some of its U.S. tax savings back to the foreign bank as an enhanced rate of return embedded in the dividend rate. (JA 393-94, 397, 401, 404-05, 407-08, 410, 2518, 2355-60, 4634). The foreign bank accepted a rate of return that was nominally lower on a pre-tax basis, but higher on an after-tax basis, than it would have received had it made a conventional loan to AIG and directly paid the foreign tax on its interest income. (JA 2353-62, 2450-51, 2802-03, 2875-76, 3053, 3758-67, 3769-72, 3776-77).

Effectively, the pre-tax rate of return on the dividend represented a split of the foreign tax between the foreign banks and AIG, and also included a payment by AIG to the foreign banks of some of the tax benefit that AIG received for claiming foreign tax credits for all of the SPV tax. (JA 2359). AIG paid the foreign bank a portion of the U.S. tax benefit it had gained to induce the bank to enter into the transaction. (JA 2321, 2325, 2339-42, 2447-51, 2458-59, 2462-63, 2477-78, 2782-83, 2875, 2893-95, 3100, 3196, 3749, 3945, 3949, 3953, 4025-29, 4634). In short, AIG used part of its U.S. tax savings (from the interest expense deduction and foreign tax credits) to pay the counterparty a favorable rate of return, and kept the rest.

Contemporaneous evidence from AIG and its counterparties confirms that the purported "borrowing" transactions were motivated entirely by tax avoidance considerations. AIG described the Laperouse Transaction, the first of the borrowing transactions, as a "tax credit deal[ ]." (JA 2310). The "core" idea behind the transaction was to exploit the difference between U.S. and French tax law (JA 2763-64), and AIG admitted that this was what "drives" the transaction (JA 2511). AIG understood that the transaction was "artificial in nature" and had a "strange and artificial appearance." (JA 3935). Nevertheless, AIG undertook substantial efforts to "make the transaction look suitably unaggressive from a U.S. tax viewpoint." (JA 3933). Its purpose was to "absorb" the French taxes paid by the SPV "through US foreign tax credits." (JA 3933). This was the "value" to AIG-FP from the Laperouse transaction. (JA 2518).⁴ Indeed, while the transaction had "virtually no credit/liquidity risk," one of its constraints was "usage of AIG's tax capacity." (JA 2524).

The subsequent borrowing transactions were modeled after Laperouse. (JA 350-51, 2334, 2523, 2613). For instance, the Vespucci transaction was described by AIG as "tax-driven." (JA 5141). AIG split the U.S. tax benefits (i.e., the value of the foreign tax credits and interest expense deduction) with the foreign counterparty through the tax-affected dividend rate. (JA 2941, 3749). And "[t]he ability of FP to claim a full credit in the U.S. for French taxes paid by the issuer [was] fundamental to the transaction" (JA 5400). Despite that, AIG sought to avoid "disclos[ing] the US tax aspect" of the transaction to the foreign revenue authority, as AIG "would not like" the foreign tax authority "look[ing] at the transaction more closely," and in fact had a "contractual arrangement [with Banca Commerciale Italiana] not to disclose the US tax aspect" of the transaction to the foreign taxing authority. (JA 5810).

The NZ Transaction was similarly tax driven. AIG's internal documents describe it as a "tax shelter." (JA 4628). Likewise, the Bank of New Zealand ("BNZ") recognized that "the basis for this transaction is tax driven benefits for both BNZ and AIG" (JA 2943), and that "[t]he US tax position is critical to the sustainability of the transaction" (JA 2958). The benefits to AIG were in the form of an interest deduction and foreign tax credits (JA 2943, 4122), and it was these benefits that supposedly provided the low borrowing cost for AIG (JA 3985). Indeed, BNZ recognized that AIG's ability to pay the dividend rate "is driven by an ability to obtain a credit in the United States for the taxes paid in New Zealand by [the SPV]." (JA 3061). BNZ noted that the transaction "enables both the Bank and AIGFP to generate attractive after-tax returns as both companies can effectively utilize the tax paid by [the SPV] in New Zealand." (JA 3061). As BNZ stated, "[t]his is a structured finance transaction which appears to be driven by tax considerations rather than a fundamental desire to borrow . . . from BNZ." (JA 2954). It further noted "[i]f this deal is 'above board' why is a AAA rated credit paying us a 1% margin for 5 years. The tax man somewhere is missing out enabling us to enhance our return." (JA 2954).

The two transactions with the Bank of Ireland -- Maitengrove and Lumagrove -- were nearly identical (JA 3139-40), and were likewise described by AIG as "TAX DRIVEN" (JA 2315) and "tax credit deals" (JA 2310). The Bank of Ireland shared this understanding. It described both transactions as "tax driven without disadvantage to the Irish Revenue" (JA 4140, 4429), and was aware that "AIG's benefit from the transaction[s] will be in the form of an excess foreign tax credit which they can offset against US tax liability on other foreign sourced income from low tax jurisdictions" (JA 4140, 4429).

The Palmgrove transaction with Irish Permanent was similar to Maitengrove and Lumagrove. (JA 2613, 3141). AIG entered into the transaction because its other borrowing transactions did not "fully address AIG's tax sheltering requirements." (JA 3190). Since AIG's purpose in entering into this transaction was to generate foreign tax credits, AIG described the transaction as a "tax credit deal" (JA 2310), as it "gives rise to an excess foreign tax credit which can be used by AIG Inc to mop up US tax liabilities on earnings from low tax jurisdictions." (JA 3196).

After describing the various tax-imbued terms of the transactions and illustrating the unconventional nature of the transactions, Dr. Cragg considered whether the amounts "borrowed" by AIG from the foreign counterparties through the transactions resulted in any pre-U.S.-tax economic gain to AIG. He found that AIG's pre-tax economic return was negative -- that is, it lost money. (JA 2361-62). In other words, the income generated by the amount supposedly borrowed by AIG through each of the transactions was insufficient to cover the SPV's operating expenses, foreign taxes, and payment of the dividend to the foreign counterparties, as AIG has acknowledged. (JA 2285, 2473, 3972). For this reason, AIG had to infuse the SPVs with substantial capital. (JA 2361). Thus, Dr. Cragg concluded that the "borrowing" transactions "were not, in fact, economic loans. They did not offer AIG prospective returns on borrowed funds sufficient to earn economic returns after covering their transaction costs (e.g., operating costs, dividends to the foreign counterparties, and taxes in the foreign jurisdictions)." (JA 2355).

Moreover, even when including AIG's own capital contribution, Dr. Cragg determined that none of the transactions would have generated "material economic profits for AIG absent the excessive [foreign tax credits] or the interest expense deductions they generated in the United States." (JA 2362). Dr. Cragg concluded that AIG's calculation of the transactions' profitability (Br. 12-13) fails, as it "does not accurately portray the economic positions of the parties absent taxes because it does not account for how the transactions inherently reflect a sharing of tax benefits" and thus "does not indicate whether there is economic purpose to these transactions beyond the acquisition of tax benefits." (JA 3759).

Similarly, the primary function of the transactions' unwind mechanisms (i.e., the agreements that AIG would repurchase the SPVs' stock in the future) was to exploit the difference between U.S. and foreign tax law. (JA 2356). These agreements allowed the foreign counterparties to claim ownership of the preferred shares for foreign tax purposes, while AIG claimed ownership of the same shares for U.S. tax purposes, even though they were held by the foreign counterparty. (JA 2320-21, 2510-14, 2944, 3128-29, 3196).

Finally, AIG's own capital contribution served no meaningful purpose other than to further its tax avoidance aims. It is undisputed that each SPV was only to have funds sufficient to pay the operating expenses of the SPVs (primarily the foreign taxes) and the dividend to the foreign counterparty. (JA 2285, 2454-55, 2514, 2615, 2830, 3120). It is likewise undisputed, as Dr. Cragg found, that a substantial portion of the SPVs' capital came from AIG (JA 2362);⁵ that in certain instances AIG had to make further capital infusions during the life of the transaction because the initial capitalization did not generate enough cash flow for the SPVs to pay their operating expenses, foreign taxes, and the dividend to the foreign counterparty (JA 3927, 3940-41); and that without AIG's substantial contributions none of the transactions would have generated a material economic return to AIG. (JA 2360, 3766).

As Dr. Cragg put it, "The creation of the various SPVs, forward sale/repurchase agreements, call/put options, or the use of AIG's own funds did not generate material non-U.S. tax benefits, if any, for AIG. However, each of these elements was undertaken and was necessary for the 'borrowing' transactions to generate the tax benefits AIG realized from them." (JA 2360).

C. The "Domestic Affiliate Transactions"

Although AIG now claims that it engaged in similar "borrowing" through domestic affiliate transactions (Br. 13-14), there is evidence that the domestic affiliate transactions themselves also were elaborate tax avoidance schemes. The principal difference is that the domestic affiliate transactions involved tax benefits at the expense of the foreign treasury, whereas the transactions at issue on this appeal involved tax benefits at the expense of the U.S. Treasury. (JA 3772). In some cases, the foreign banks refused to participate in AIG's proposed domestic transactions because of concerns about a negative reaction from the relevant foreign taxing authority. (JA 2322 (Bank of Ireland refused to participate in domestic predecessor to Maintengrove transaction because it "could be deemed to have as its primary object the avoidance of Irish tax"), 4633 (New Zealand counterparties "were a bit nervous" about proposed domestic transactions), 5842-43 (certain domestic transactions unwound because of changes in Australian tax law)). The counterparties did not have similar concerns about the foreign borrowing transactions at issue here, which implicated the U.S. Treasury. (JA 2321 (Bank of Ireland noted that Maintengrove transaction caused "no loss of Irish tax revenue"), 4429 (describing Lumagrove transaction as "tax driven without disadvantage to the Irish revenue")).⁶

D. The District Court's Decision

In an opinion and order dated March 29, 2013, the district court denied AIG's second motion for partial summary judgment, which was limited to the six "borrowing" transactions. (SPA 1-16). The district court first held that the economic substance doctrine applies to the foreign tax credit regime. (SPA 7-10). After noting that the economic substance doctrine is a two-part analysis requiring the taxpayer to prove that a transaction has a "business purpose" and "reasonable possibility of profit apart from tax benefits," the district court found those requirements "consonant with the purpose of the foreign tax credit, because Congress intended the credit to facilitate purposive business transactions, not by subsidy, but by restoring the neutrality of the tax system." (SPA 8 (quotation marks omitted)). The district court emphasized that Congress enacted the foreign tax credit for the benefit of "the taxpayer who desires to engage in purposive activity," not for "transactions that have no economic utility and that would not be engaged in but for the system of taxes imposed by Congress." (SPA 10 (quotation marks omitted)).

The district court next considered the existing factual record, and whether AIG had shown there was no genuine dispute of material fact regarding whether they had economic substance. (SPA 11-16). The district court noted that AIG's pre-tax profit calculation did not exclude the tax effects on the foreign counterparty's dividend. (SPA 13). The district court determined that there was record evidence that "AIG's ability to 'borrow' at sub-market rates was the result of 'transaction terms which included AIG-FP paying the counterparties a tax-affected dividend rate.'" (SPA 14 (quoting JA 3770)). Moreover, the district court recognized that "the SPV's distribution to the bank being tax-exempt was not a trivial or speculative factor: it shaped the transactions." (SPA 15). The district court thus denied AIG's motion for partial summary judgment. (SPA 16).

By order dated November 4, 2013, the district court certified its order for interlocutory appeal. The court noted that the possibility of double taxation caused by disallowance of the foreign tax credit could raise a substantial question as to whether the economic substance doctrine should apply. (SPA 20-21). The court also recognized that decisions of two other federal courts of appeals could affect how foreign tax benefits shared with a U.S. party are treated under the economic substance doctrine. (SPA 21-23). Accordingly, the court certified its order denying summary judgment for appeal under 28 U.S.C. § 1292(b). (SPA 23). This Court then granted AIG permission to appeal.

First, the district court correctly held that the economic substance doctrine applies to transactions, such as AIG's "borrowing" transactions, involving foreign tax credits. The economic substance doctrine permits courts to disallow tax benefits arising from transactions that technically comply with the Tax Code, but which have no purpose, substance, or utility apart from their tax consequences. Like other judicial anti-abuse doctrines, the economic substance doctrine serves to ensure that taxpayers may not obtain tax benefits that Congress did not intend, even when a transaction complies with the literal terms of the tax statutes and regulations. And Congress did not intend the foreign tax benefit to extend to economically empty transactions. The foreign tax credit regime was established to neutralize the effect of U.S. taxes on the decision of where to do business, not to subsidize a taxpayer's operations at the expense of the U.S. Treasury. Thus, there has never been a foreign tax credit exception to the economic substance doctrine. Any such exception would only embolden creative taxpayers to design transactions such as those at issue in this case -- transactions that comply with the letter of the law but result in an accumulation of foreign tax credits that Congress never intended to confer. See infra Point I.

Second, there are numerous issues of disputed fact concerning whether AIG's transactions had economic substance. In this Court, the economic substance inquiry is a flexible test, assessing the taxpayer's subjective business purpose for entering into the transaction and the objective economic effects of the transaction. The record shows that AIG and its counterparties subjectively viewed the transactions as vehicles for tax avoidance, entered into them for that reason, and structured them to further that purpose. See infra Point II.B.1. And even though expert discovery has not yet commenced, the record also shows that the transactions had no objective economic basis absent the accumulation of tax benefits. AIG has not offered any expert analysis, or any evidence for that matter, that establishes that the transactions were profitable except for the foreign tax credits that were generated. In contrast, the government has put forth expert declarations showing that no reasonable investor would have entered into these transactions absent the claimed tax benefits. Other factors also demonstrate that the transactions had no real economic effects. See infra Point II.B.2. AIG attempts to rebut this evidence through its own pre-tax profit calculation, but that conclusory analysis fails to take account of how the transactions actually worked to exploit differences in foreign and U.S. tax laws, and to split the U.S. tax benefit between AIG and its foreign counterparties. Nor is AIG helped by two decisions it cites from other circuits, which are both factually inapposite and legally wrong. See infra Point II.C.

Finally, even if this Court agrees with AIG's arguments, the record supports affirmance independent of the district court's decision because the government has challenged the transactions under the substance-over-form or step-transaction doctrines, which are separate and distinct from the economic substance doctrine. AIG has not briefed these doctrines to the district court or this Court. See infra Point III.

In an interlocutory appeal under 28 U.S.C. § 1292(b), "appellate jurisdiction applies to the order certified to the court of appeals, and is not tied to the particular question formulated by the district court" or the parties. Yamaha Motor Corp., U.S.A. v. Calhoun, 516 U.S. 199, 205 (1996).⁷

A. Application of the Economic Substance Doctrine Is Consistent with the Purpose of the Foreign Tax Credit Regime

The Supreme Court long ago established the fundamental principle that transactions that lack economic substance will not be recognized for federal tax purposes. See Gregory v. Helvering, 293 U.S. 465, 468-70 (1935). The economic substance doctrine provides that the tax consequences of a transaction may be disregarded if the transaction "can not with reason be said to have purpose, substance or utility apart from [its] anticipated tax consequences." Goldstein v. Comm'r, 364 F.2d 734, 740 (2d Cir. 1966); accord Knetsch v. United States, 364 U.S. 361, 365-66 (1960); Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir. 2002); DeMartino v. Comm'r, 862 F.2d 400, 406 (2d Cir. 1988). This doctrine "allows courts to enforce the legislative purpose of the [Tax] Code by preventing taxpayers from reaping tax benefits from transactions lacking in economic reality." Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 543 (5th Cir. 2009).⁸

This Court has repeatedly held that "even if a transaction's form matches 'the dictionary definitions of each term used in the statutory definition' of the tax provision, 'it does not follow that Congress meant to cover such a transaction' and allow it a tax benefit." Altria Group, Inc. v. United States, 658 F.3d 276, 284 (2d Cir. 2011) (quoting Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff 'd, 293 U.S. 465 (1935)); accord DeMartino, 862 F.2d at 407; Ferguson v. Comm'r, 29 F.3d 98, 101 (2d Cir. 1994) ("An activity will not provide the basis for deductions if it lacks economic substance"); Diggs v. Comm'r, 281 F.2d 326, 329-30 (2d Cir. 1960). Virtually all sophisticated tax shelters are designed to satisfy the relevant tax rules, but courts nevertheless consistently reject these shelters under the anti-abuse doctrines. See Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1353-54(Fed. Cir. 2006). As these decisions make clear, the "analysis of whether [the transaction] is a sham . . . must occur before" any statutory or regulatory analysis because those rules do "not apply where the transactions involved are shams," Kirchman v. Comm'r, 862 F.2d 1486, 1491 (11th Cir. 1989), no matter how "detailed" the relevant rules are.

Thus, the economic substance doctrine is a "general principle for construing revenue statutes." Diggs, 281 F.2d at 329. And there is nothing to suggest that this general principle should not be applied to the foreign tax credit regime as well. Indeed, while there may be some transactions for which "Congress has clearly intended tax relief irrespective of the parties' motives," "at the least Gregory v. Helvering requires that a taxpayer carry an unusually heavy burden when he attempts to demonstrate that Congress intended to give favorable tax treatment to the kind of transaction that would never occur absent the motive of tax avoidance." Id. at 330; see also Astoria Fed. Sav. & Loan Ass'n v. Solimino, 501 U.S. 104, 108(1991) ("the courts may take it as given that Congress has legislated with an expectation that [an established common-law] principle will apply except 'when a statutory purpose to the contrary is evident'" (citation omitted)). AIG falls far short of carrying that burden here.

As the district court correctly held, the foreign tax credit regime was "'designed to produce uniformity of tax burden among United States taxpayers,'" regardless of whether they "'engaged in business'" in the United States or abroad. (SPA 8 (quoting H.R. Rep. 83-1337, at 76 (1954))). As the Supreme Court has put it, foreign tax credits have "dual purposes": to mitigate "double taxation" of a company's income, and to "equalize treatment" between U.S. corporations that operate foreign branches and foreign subsidiaries. United States v. Goodyear Tire and Rubber Co., 493 U.S. 132, 139-41, 143 (1989); accord Burnet v. Chicago Portrait Co., 285 U.S. 1, 7-9 (1932) (purposes to mitigate "double taxation" and to "facilitate [domestic corporations'] foreign enterprises"). Thus, the foreign tax credit neutralizes the effect of U.S. taxes on the decision of where to conduct business activities most productively, 56 Cong. Rec. App. 677-78 (1918) (statement of Rep. Kitchin), so that "investment-location decisions are governed by business considerations, instead of by tax law," U.S. Congress Joint Committee on Taxation, The Impact of International Tax Reform: Background and Selected Issues Relating to U.S. International Tax Rules and the Competitiveness of U.S. Businesses 3 (JCX-22-06)(June 21, 2006), available at http://www.jct.gov/x-22-06.pdf.

Transactions designed to exploit the foreign tax credit regime are not consistent with this business-focused legislative purpose, which contradicts any suggestion that Congress meant to shield economically empty activity from tax. AIG accordingly cannot meet its "heavy burden" to demonstrate that the economic substance and other anti-abuse doctrines should not apply to transactions involving foreign tax credits. Diggs, 281 F.2d at 330. Indeed, lower courts have recognized that "FTCs are available to prevent double taxation, not to generate an enhanced return on the basis of structuring transactions to increase the available FTCs." Pritired 1, LLC v. United States, 816 F. Supp. 2d 693, 741 (S.D. Iowa 2011). Thus, "[t]here is no foreign tax credit exception to the economic substance doctrine." Salem Fin., Inc. v. United States, 112 Fed. Cl. 543, 584 (2013), appeal docketed,No. 14-5027 (Fed. Cir.); see Bank of New York Mellon Corp. v. Comm'r, 140 T.C. 15 (2013) (applying doctrine), appeal docketed, No. 14-704 (2d Cir.); InterTAN, Inc. v. Comm'r, 87 T.C.M. (CCH) 767 (2004)(same), aff 'd, 117 F. App'x 348 (5th Cir. 2004); Compaq Computer Corp. v. Comm'r, 113 T.C. 214 (1999)(same), rev'd on other grounds, 277 F.3d 778 (5th Cir. 2001).

AIG nonetheless contends that the economic substance doctrine cannot apply to transactions involving foreign tax credits, because the foreign tax credit is governed by "complex rules." (Br. 20, 24-26). But the existence of a highly developed statutory or regulatory scheme does not trump the economic substance doctrine. In Gregory v. Helvering itself, the Supreme Court applied the doctrine even though the statutory requirements were met: "though conducted according to the terms" of the statute, the transaction "was in fact an elaborate and devious form of conveyance masquerading" as legitimate, and therefore "lies outside the plain intent of the statute." 293 U.S. at 470. "To hold otherwise would be to exalt artifice over reality and to deprive the statutory provision in question of all serious purpose." Id. This Court and others have similarly rejected arguments that compliance with statutory or regulatory terms alone makes an undertaking exempt from the general principle that only transactions with economic substance merit the tax relief Congress has awarded. Gardner v. Comm'r, 954 F.2d 836, 838 (2d Cir. 1992); In re CM Holdings, 301 F.3d 96, 102 (3d Cir. 2002).

The foreign tax credit regime is no different from other statutory provisions granting tax benefits. Many of these regimes are complex and are subject to abuse by creative taxpayers -- a fact that underlies the judicial creation of anti-abuse doctrines, but that is ignored by AIG's suggestion that the foreign tax credit statutes and regulations "fully implement the purpose of those provisions." (Br. 25); see ASA Investerings P'ship v. Comm'r, 201 F.3d 505, 513 (D.C. Cir. 2000) ("Even the smartest drafters of legislation and regulation cannot be expected to anticipate every [tax avoidance] device."). This Court rejected the same argument eighty years ago: "[I]t does not follow that Congress meant to cover . . . a transaction, . . . even though the facts answer the dictionary definitions of each term used in the statutory definition." Helvering v. Gregory, 69 F.2d at 810. The application of the economic substance doctrine to transactions involving foreign tax credits does not "supplant" the foreign tax credit rules, as AIG suggests. (Br. 22). Instead, the doctrine prevents subversion of the legislative purpose of those rules.⁹

AIG relies on Estelle Morris Trusts v. Comm'r, 51 T.C. 20 (1968), to argue that courts should not apply the economic substance doctrine when "the statute or regulation reflects a history of detailed consideration by Congress." (Br. 28). But in that case, involving the use of multiple trusts for tax avoidance, the court held that Congress had "sanction[ed]" the use of single trusts for that purpose, that the use of multiple trusts was merely an extension of that congressionally approved conduct, and that Congress had resisted numerous proposals to prohibit the use of multiple trusts. 51 T.C. at 39-43. This evidence demonstrated, the court held, "congressional recognition" and "detailed consideration" of the issue, and therefore the economic substance doctrine should not apply because nothing showed that "tax-motivated trusts necessarily lie outside [the statute's] plain meaning." Id. at 42-43.¹⁰ In this case, in contrast, there is no evidence that Congress ever intended the economic substance doctrine not to apply to the foreign tax credit regime.

To the contrary, Congress codified the economic substance doctrine prospectively in 2010 without any exception for foreign tax credit deals at a time when this case and others were already pending. 26 U.S.C. § 7701(o).¹¹ Moreover, in enacting § 7701(o), Congress recognized that "[a] strictly rule-based tax system cannot efficiently prescribe the appropriate outcome of every conceivable transaction that might be devised and is, as a result, incapable of preventing all unintended consequences," and "the fact that a transaction does meet the requirements for specific treatment under any provision of the Code is not determinative of whether a transaction or series of transactions of which it is a part has economic substance." H.R. Rep. No. 111-443, pt. 1, at 295, 296 (2010). While Congress's clarification of the economic substance doctrine is not retroactive, it reaffirmed the courts' decades-long utilization of the economic substance doctrine to disallow tax benefits that Congress never intended even when a statute's literal terms have been satisfied.

B. AIG's Remaining Arguments Are Unpersuasive

AIG's remaining arguments against application of the economic substance doctrine to foreign tax credits are similarly without merit. First, AIG suggests (Br. 30-31) that the government's position is inconsistent with the technical taxpayer rule, which provides that a foreign tax "is considered paid for purposes of section 901 and 903 [by] the person on whom foreign law imposes legal liability for such tax." Treas. Reg. § 1.901-2(f)(1); see Biddle v. Comm'r, 302 U.S. 573 (1938). But that rule has nothing to say about the economic substance doctrine. Instead, with respect to legitimate transactions that have economic substance, it eliminates the need to look into who actually paid the foreign tax.

Second, AIG asserts that the government "took issue" with its transactions because they generated "excess" foreign tax credits. (Br. 32). But the government does not contend that excess foreign tax credits, standing alone, are necessarily impermissible. What is impermissible is that the sole purpose of these transactions was to generate excess foreign tax credits and other tax benefits -- that is, that they lack economic substance. Similarly, AIG misses the point in criticizing the government for noting that the transactions were designed to arbitrage U.S. and foreign tax laws. (Br. 36-37). "[T]he taxpayer has an unquestioned right to decrease or avoid his taxes by means which the law permits," but "the law does not permit the taxpayer to reap tax benefits from a transaction that lacks economic reality." Coltec Indus., 454 F.3d at 1355. The various IRS publications and statements of IRS officials that AIG cites (Br. 34-37) are consistent with that principle. In fact, the only IRS publication cited by AIG that considered a taxpayer's entitlement to foreign tax credits found that the credits were properly claimed because, among other things, the transaction in question "ha[d] economic significance beyond generating foreign tax credits" and there was "a business and economic profit motive." IRS Tech. Adv. Mem. 9821003 (May 22, 1998) (emphasis added).

The district court thus correctly held that nothing prevents application of the economic substance doctrine to transactions involving foreign tax credits, including AIG's so-called "borrower" transactions. A ruling to the contrary would effectively enable clever taxpayers and their advisors to construct any number of transactions that comply with the literal terms of the Tax Code, but whose sole purpose is to claim foreign tax credits in situations that Congress never intended. As the purpose of the foreign tax credit regime is to encourage neutral tax treatment for U.S. companies' business abroad, not to exploit the Code through economically useless transactions, this Court should hold that the economic substance doctrine applies here.

A. The Economic Substance Doctrine

To prevail on the economic substance doctrine, AIG has the burden of demonstrating that it engaged in "transaction[s] with economic substance" that are "imbued with tax-independent considerations" and not "shaped solely by tax-avoidance features that have meaningless labels attached." Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978); accord Gilman v. Comm'r, 933 F.2d 143, 147 (2d Cir. 1991)(taxpayer required to show that prudent investor would have concluded that there was realistic opportunity for non-tax-based profit); DeMartino, 862 F.2d at 406 ("burden was on the taxpayer to demonstrate that the purported trades were bona fide"); United States v. Bergbauer, 602 F.3d 569, 578 (4th Cir. 2010). This Court has held that the economic substance analysis is a "flexible" analysis that includes both subjective and objective inquiries: whether the taxpayer was motivated by a non-tax "business purpose," and the objective economic effects of the transaction. Gilman, 933 F.2d at 147-48; accord Nicole Rose Corp., 320 F.3d at 284.

Whether a transaction has economic substance "is a question of fact," Nicole Rose, 320 F.3d at 284; accord Lee v. Comm'r, 155 F.3d 584, 586 (2d Cir. 1998),requiring consideration of both the subjective and objective components of the analysis, Gilman, 933 F.2d at 147-48 (noting this Court's support of the "business purpose/economic effect analysis of sham transactions"); Altria Group, Inc. v. United States, 694 F. Supp. 2d 259, 282 (S.D.N.Y. 2010) ("The Court understands Second Circuit law to require an analysis under which the factfinder must consider both aspects of the economic substance inquiry, and may (but need not) find against the taxpayer if a transaction lacks either a legitimate purpose or an economic effect."), aff 'd, 658 F.3d 276 (2d Cir. 2011); Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 171 n.68 (D. Conn. 2004) ("proper" to consider both components of the analysis in this circuit), aff 'd, 150 F. App'x 40 (2d Cir. 2005). A transaction may lack economic substance if the factfinder concludes that the taxpayer has failed to satisfy either component. See Nicole Rose, 320 F.3d at 284 (transaction is a sham "if it has no business purpose or economic effect other than the creation of tax deductions"); Gilman, 933 F.2d at 147 (same); Jacobson v. Comm'r, 915 F.2d 832, 837 (2d Cir. 1990) (same); DeMartino, 862 F.2d at 406 (same).¹²

B. Even Though Discovery Is Incomplete, There Are Genuine Disputes of Fact as to Whether the Transactions Have Economic Substance

AIG's own internal documents prove that AIG itself believed that the purpose of the transactions was to create tax benefits. AIG personnel described the transactions internally as "tax-driven" "tax credit deals," "tax based deal[s]," "FTC [ i.e., foreign tax credit] trade[s]," "tax-related trade[s]," "Tax Deals" and tax "shelters." (JA 2310, 2311, 2315, 2317, 4140, 4429, 4628, 5141). AIG's internal analysis shows that the "value for AIG-FP" from these deals was that foreign taxes would be "consolidated into AIG's U.S. tax return and credited against AIG's U.S. tax bill." (JA 2518). AIG-FP believed that foreign tax credits were "fundamental to the transaction[s]" (JA 5400), and that if "the foreign tax credit [were] disallowed, it would presumably be fatal to the transaction from AIG-FP's viewpoint" (JA 2914). And AIG-FP marketed the deals to the counterparties as "tax transactions." (JA 5170-71). This evidence in and of itself is sufficient to create a question of fact on AIG's subjective business purpose that cannot be resolved on summary judgment.

In addition, AIG's counterparties likewise understood that they were not entering into legitimate spread-banking transactions with AIG, but rather "tax driven transaction[s]." (JA 2943, 4429). An AIG counterparty acknowledged that the "benefit to AIG [from the transactions] comes from US tax laws whereby they can obtain a credit for the [foreign] tax . . . and a deduction for the . . . dividend paid," and that the "tax credit effectively reduces [AIG-FP's] cost of borrowing." (JA 2319). Another counterparty similarly observed that "AIG's benefit from the transaction will be in the form of an excess foreign tax credit which can be offset against its US tax liability on other foreign sourced income from low tax jurisdictions." (JA 4429). As one counterparty succinctly commented, "If the deal is 'above board' why is a AAA rated credit paying us a 1% margin for 5 years. The tax man somewhere is missing out. . . ." (JA 2954).¹³

Not surprisingly, the foreign tax credits generated from the transactions were of supreme importance to AIG. AIG-FP structured the deals so that it could terminate them if AIG could not absorb the foreign tax credits generated. (JA 2320, 2537, 2590, 3094-95, 3313, 5188, 5221, 5230, 5336). Prior to entering into the transactions, AIG-FP conducted detailed analyses to make sure that AIG would have sufficient tax capacity to utilize the credits, and the transactions were submitted to AIG's tax department for approval. (JA 487-89, 2536, 2772, 2802-04). AIG-FP kept track of the excess credits that were generated and used, and measured its profits from the transactions in terms of tax credits that were generated. (JA 4099, 4103, 4105-06, 4612, 4618).

Finally, the SPVs that AIG-FP created to facilitate the transactions were simply shells that had no legitimate business purpose. The SPVs undertook no substantive business activities, and had no employees other than their "directors," little or no office space, and no profits. (JA 2962-83, 3130, 3207-21, 3366-82). The SPVs could not cover their own expenses, foreign taxes, and dividend payments without substantial cash infusions from AIG-FP to cover the shortfall in cash flow due to insufficient income from the "borrowed" funds. (JA 2285, 2361, 2473, 3972). The deals were structured to permit both parties to claim ownership of the SPVs, enabling AIG to claim foreign tax credits and interest deductions in the United States.

AIG's factual assertion that it was conducting the same spread-banking deals overseas that it conducted through "domestic" transactions (Br. 52) only serves to underscore a genuine dispute of fact -- notwithstanding AIG's representation to the district court that the domestic transactions are not material to the transactions at issue on this appeal. The transactions with U.S.-based affiliates, the mirror-images of those at issue here, triggered concerns from foreign banks about the reaction of their home-country treasuries. (JA 2322, 5842-43). It is difficult to see how AIG can show a legitimate business purpose by pointing to other transactions that use similar schemes to evade non-U.S. taxes.

AIG's assertion that it need not satisfy the business purpose prong (Br. 52-53) is meritless, and has been squarely rejected by this Court. See Gilman, 933 F.2d at 147-48 (rejecting argument that the sole inquiry is whether there was a change in the economic positions of the parties); Altria Group, Inc., 694 F. Supp. 2d at 282 (rejecting taxpayer argument that taxpayer need not show business purpose after demonstrating a pre-tax profit); Long Term Capital Holdings, 330 F. Supp. 2d at 171 (same). While it is true that a taxpayer may permissibly act to minimize tax liability, it is not true that a taxpayer may undertake a transaction with no business purpose at all in order to obtain a tax benefit. Rosenfeld v. Comm'r, 706 F.2d 1277, 1278 (2d Cir. 1983) (while "taxpayers are generally free to order their . . . decisions to reduce their tax liability," "[w]hen such schemes completely lack legitimate purposes and affect no real economic or beneficial interests, courts have not hesitated to pierce the formal arrangements and examine the substance of the underlying transaction"); Garlock, Inc. v. Comm'r, 489 F.2d 197, 201 (2d Cir. 1973)(contrasting permissibility of minimizing taxes with transactions that "lacked a business purpose" where Congress's aim "was to approve only [transactions] having such a [business] purpose"). Thus it is not true that, as AIG claims, a taxpayer's "subjective motive . . . is irrelevant if the transaction has objective economic effects." (Br. 52). The relative weights of the subjective and objective prongs are a matter for the jury, and both prongs must be considered as part of the "flexible" analysis. Gilman, 933 F.2d at 148.¹⁴

In light of the foregoing, there is more than enough evidence in the record to demonstrate a question of material fact as to whether AIG had a legitimate non-tax business purpose in entering into the transactions at issue -- particularly given that the Court must construe the evidence in the light most favorable to the government. AIG thus is not entitled to summary judgment under the economic substance analysis.

To satisfy the objective economic effects prong of the economic substance doctrine, AIG must demonstrate that the transactions afforded "a reasonable opportunity for economic profit . . . exclusive of tax benefits," approached from the standpoint of a "prudent investor." Gilman, 933 F.2d at 146-47. This is also a question of fact that necessarily turns on an economic analysis of the transactions and the reasonableness of expected non-tax benefits. See Jacobson, 915 F.2d at 837 (conclusion that transaction lacks economic substance is a question of fact; legal standard to be applied in making that determination is a question of law). That inquiry frequently requires expert economic analysis, particularly in highly structured transactions. See, e.g., Gilman, 933 F.2d at 147 (taxpayer and government offered expert witnesses on issue of non-tax profit of transaction); Nicole Rose Corp., 320 F.3d at 284 (affirming ruling based on testimony of expert retained by the IRS that transaction lacked economic substance); Long Term Capital Holdings, 330 F. Supp. 2d at 160-65 (discussing parties' experts).

In this litigation, expert discovery has not even commenced, and AIG has offered no expert evidence in support of its conclusory analysis of the transactions. On the other hand, the economist retained by the government, Dr. Cragg, has submitted two declarations showing that the transactions lacked economic effects apart from tax benefits. Those declarations set forth Dr. Cragg's preliminary analysis concerning the underlying economics of the transactions. Based on his initial review of the transactions, Dr. Cragg opined, among other things, that (1) the "borrowing" transactions were not "economic loans" and "did not offer AIG prospective returns on borrowed funds sufficient to earn economic returns after covering their transaction[ ] costs"; (2) the transactions "inflated the foreign tax liabilities of the SPVs and generated income from tax benefits for AIG at the direct expense of the United States"; (3) "absent the claimed tax benefits, the transactions neither generated material economic returns for AIG, nor offered the potential for such returns, after accounting for dividend payments, operating expenses, and foreign taxes"; and (4) "[a] rational investor . . . would not have engaged in the transactions absent the tax benefits." (JA 2353-66, 3758).

As Dr. Cragg explains, to measure the extent to which these transactions afford a reasonable opportunity for economic profit apart from tax benefits, it is necessary to understand the commercial substance of the transaction and account for all tax benefits derived from the transaction, including tax benefits incorporated into its terms and structure. (JA 3767-74). One of the key tax benefits of the "borrowing" transactions was the parties' ability to effectively split the cost of the foreign lender's tax liabilities, while passing on the full cost to the U.S. Treasury. (JA 3761-63). By shifting the lender's foreign tax into the SPV and funding part of it, AIG was able to set nominal dividend rates that were lower than the market interest rates the lenders would otherwise earn. (JA 3761-63). What would otherwise have been interest payments to the foreign counterparties were converted into creditable foreign taxes, while the rates on the "dividend" payments to the foreign counterparties reflected negotiated splits of AIG's U.S. tax benefits. (JA 3761-65, 3770-72). But none of this tax manipulation had any non-tax economic effect: as Dr. Cragg opined, no reasonable investor would have viewed these transactions as economically profitable absent the tax benefits they generated. (JA 2353, 2365, 3777).

In addition, there are a number of other objective factors demonstrating that the transactions lack economic effects. First, AIG did not assume any material risk in connection with the transactions. (JA 3765). Second, AIG created numerous straw entity SPVs that had no significant business activities, no employees other than their "directors," and no apparent purpose other than to facilitate the generation of U.S. tax benefits. (JA 2365-66, 3766). Third, the transactions involved out-of-market pricing driven by the splitting of tax benefits. (JA 2353-54, 3758-68). Fourth, AIG could not have profited from its "borrowing" transactions based solely on the amounts "borrowed" from the foreign counterparties. (JA 2360-62, 3766). Absent substantial contribution of capital from AIG, the SPVs would not have had sufficient cash flow to pay their own expenses (including foreign tax) and the dividends paid to foreign counterparties. (JA 2360-62, 3766). Finally, the value of the foreign tax credits produced by the transactions vastly exceeded the little, if any, economic profit AIG realized apart from tax benefits. (JA 2353-54). In other words, AIG committed substantial capital of its own to each of the transactions, paid substantial transaction costs (including the compensation of AIG-FP principals for the claimed tax credits), and expected at their conclusion to have substantially less than its original investment excluding the value of the foreign tax credits.

All of these facts are reasons that a reasonable factfinder could find that the transactions fail the objective prong of the economic substance test. See, e.g., Dow Chemical Co. v. United States, 435 F.3d 594, 603 n.15 (6th Cir. 2006) (considering elimination of risk in finding no economic substance); ACM P'ship v. Comm'r, 157 F.3d 231, 249-52 & n.39 (3d Cir. 1998)(considering offsetting investments and minimal risk); Gregory, 293 U.S. at 469 (1935) (considering straw entities); DeMartino, 862 F.2d at 404, 406 (considering non-market prices); Ferguson v. Comm'r, 29 F.3d 98, 101-02 (2d Cir. 1994) (same); ASA Investerings, 201 F.3d at 515-16 (no economic substance where tax benefits were larger than non-tax profits). Accordingly, Dr. Cragg's preliminary analysis and the evidence in the record more than support the district court's denial of partial summary judgment. See Black & Decker Corp. v. United States, 436 F.3d 431,441-42 (4th Cir. 2006) (reversing summary judgment for taxpayer where IRS presented expert reports explaining why the transaction lacked economic substance, and concluding that such evidence should be weighed by finder of fact at trial).

C. The Court Should Reject AIG's Pre-Tax Profit Calculation

Notwithstanding a record replete with questions of fact on both prongs of the economic substance test, AIG contends that it is entitled to partial summary judgment because its transactions were profitable on a "pre-tax" basis. (Br. 38-51). But as Dr. Cragg explained, AIG's pre-tax profit analysis is misleading because it does not account for how the transactions, at their core, reflect a sharing of U.S. tax benefits by AIG and the foreign counterparty, and thus does not accurately portray the parties' economic positions apart from tax benefit. (JA 3759). How the transactions actually worked, and their economic effects, are factual questions for a jury, and are enough to defeat summary judgment.

To avoid that conclusion, AIG attempts to recast the issue as a pure question of law, relying heavily on two decisions of other courts of appeals: Compaq Computer Corp. v. Comm'r, 277 F.3d 778 (5th Cir. 1999), and IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001). Both of these cases, however, are distinguishable on their facts and, in any event, should not be followed in this case.

This calculation, offered to the Court without any supporting expert analysis or testimony, is at best misleading and incomplete, because it does not pierce the camouflage of the tax benefits in the transaction. AIG's simplistic approach hides how its borrowing costs inherently reflect a sharing of U.S. tax benefits, and does not identify whether the use of SPVs or the terms of the transactions were purely tax-driven. (JA 3759). As Dr. Cragg points out, AIG "merely calculates the distribution of cash flows from the transactions as they were stated, but without paying taxes. This calculation in no way answers the question of whether the transactions created material economic value unrelated to taxes." (JA 3760). Put differently, AIG's superficial pre-tax profits analysis purportedly calculates cash flows from the transactions without the payment of taxes, but does not assess whether the transactions created material economic value apart from taxes. (JA 3760). As Dr. Cragg states, "calculat[ing] profitability before taxes is not always the same as calculating economic profit absent tax benefits."(JA 3760).

According to Dr. Cragg, "the terms of the AIG transactions have embedded within them the shared tax benefits, which appear to be the only economic effects of the transactions." (JA 3760). AIG's analysis cannot present an economically meaningful view of the transactions' profitability apart from tax benefits because it simply removes the mere payment of taxes, rather than identifying the effect of taxes on the terms and structure of the transactions. (JA 3760-61). Any favorable dividend rate that AIG was able to negotiate with the counterparties reflects the non-market pricing made possible only by converting interest expense into creditable taxes, claiming U.S. foreign tax credits, and sharing the U.S. tax benefit -- in effect, having the U.S. Treasury pay. (JA 3761-62). By eliminating the payment of foreign taxes from the pre-tax profit test but not acknowledging that the pricing of the dividends resulted from shifting the lenders' tax liabilities to the SPVs, AIG's analysis fails to account for the tax benefits that AIG incorporated into the terms of the transactions. (JA 3760-61, 3769-72).

AIG argues that analyzing these transactions by adjusting for these built-in tax effects -- "grossing up," as AIG puts it -- is improper, suggesting that that method "does not reflect the actual cash flows of an investment." (Br. 18, 42-43). But the nature of the cash flows of these transactions is a question of fact -- and in this case, a disputed one. Dr. Cragg has indicated that for these transactions, it is economically correct to treat the foreign taxes paid by the SPVs in this case as expenses, given that "the SPVs' pre-foreign tax profits were artificially inflated because the SPVs effectively paid foreign income taxes on behalf of AIG-FP's foreign counterparties" -- in other words, the foreign tax payments should be accounted for in the pre-tax profit calculation in the same way as the interest expenses they replaced. (JA 3775). Indeed, a reasonable juror could infer from the record that AIG also viewed foreign taxes as an expense in measuring the profitability of the transactions. (JA 4043, 4045, 4050, 5970).

As the district court put it, "the SPV's distribution to the bank being tax-exempt was not a trivial or speculative factor: it shaped the transactions." (SPA 15). The economic substance doctrine requires an analysis of the essential elements of the entire transaction -- in this case, to determine how to separate U.S. tax effects from any non-tax economic benefits of the transactions. This must be done case by case, not categorically, as AIG suggests. See Nicole Rose, 320 F.3d at 284; Jacobson, 915 F.2d at 839; Long Term Capital, 330 F. Supp. 2d at 186 (economic substance is "case by case, fact-based inquiry").

For that reason, AIG is wrong to argue that this case turns on a question of law, whether the effect of a foreign tax benefit to a foreign party should be included in the pretax profit test. The record shows that AIG's premise is false: this case is not about a foreign tax benefit given to a foreign party, but about a U.S. tax benefit shared between a U.S. corporation and its foreign counterparty. The foreign tax benefit to the foreign counterparty, i.e., the tax exemption applicable to the dividend, was available because the transaction effectively allowed the foreign taxing authority to receive what the foreign bank otherwise would have owed, through tax payments from the SPV. The U.S. Treasury alone funded the benefits to all parties in the transaction. As Dr. Cragg points out, "AIG increased the dividends to the foreign counterparties to induce their participation in this complex structure, in effect splitting the value of U.S. FTCs through the dividend rate." (JA 2360).

In any event, these matters are disputed questions of fact. The tax position of a foreign counterparty can inform the economics of a transaction, which needs to be evaluated case by case under this Court's flexible framework for assessing economic substance. See Nicole Rose, 320 F.3d at 284; Jacobson, 915 F.2d at 839. AIG cannot avoid that inquiry by artificially and incorrectly framing this appeal as a pure question of law.

The Compaq and IES cases involved transactions in which the taxpayers purchased publicly traded foreign securities known as American Depository Receipts ("ADRs") at market prices. At the time of purchase, the securities were about to pay a dividend, which was subject to a 15% foreign tax. Compaq, 277 F.3d at 779-80; IES, 253 F.3d at 351-53. The price of those securities was therefore the market price plus 85% of the impending dividend. Compaq, 277 F.3d at 779-80; IES, 253 F.3d at 352. The taxpayer-buyer then received the dividend minus the foreign tax -- thus enabling it to claim foreign tax credits (which were not available to the sellers of the securities be-cause those sellers were tax-exempt and accordingly had no U.S. taxes against which to claim the foreign tax credit). Compaq, 277 F.3d at 779-80; IES, 253 F.3d at 352. The taxpayer then resold the securities, for the market price with no addition for the now-paid dividend, back to the original seller, incurring capital losses the taxpayer could use as deductions. Id. In short, the taxpayer bought the right to receive the dividend at a price discounted for the foreign tax; paid the foreign tax but received a credit to use against U.S. tax liabilities; and resold the securities back to the original seller. Id.

In those cases, the taxpayers claimed (and the courts of appeals accepted) that they had earned a pre-tax profit: the difference between the amounts the taxpayer received (from selling the ADRs and from the gross dividends) and the amount it paid (from purchasing the ADRs and from expenses). Compaq, 277 F.3d at 785-86; IES, 253 F.3d at 354-55. That calculation did not take into account the foreign taxes that had been withheld from the dividend payments. Compaq, 277 F.3d at 785; IES, 253 F.3d at 353-54.¹⁵

The courts assessed the economic substance of the transactions on these more complete records, and relied on significant differences from the transactions here. The courts determined that the taxpayers' motivations were not solely to obtain tax benefits, but also to make a pre-tax profit. Compaq, 277 F.3d at 787; IES, 253 F.3d at 354-55. The taxpayers in those cases also conducted their transactions "on a public market, not in an environment controlled by" the taxpayer, and therefore bore real risks from the transactions. Compaq, 277 F.3d at 787; see IES, 253 F.3d at 355. Moreover, in both cases the courts held it "important" that "these were not transactions conducted by alter-egos of [the taxpayer] or straw entities created by [the taxpayer] simply for the purpose of conducting" those transactions. IES, 253 F.3d at 355; accord Compaq, 277 F.3d at 784.

All of those facts distinguish Compaq and IES from the current case, where AIG's motivation is in dispute, and where, as confirmed by Dr. Cragg's preliminary opinion, AIG did in fact set up special entities solely to conduct the transactions outside any public market and bore no real risk in the transactions. (JA 2365-66, 3758, 3761-67, 5967, 5980). In fact, unlike the prices in Compaq and IES, which were set on public markets, the prices paid by the parties in this case deviate from the prices that would be realized in competitive markets. (JA 3758, 3761-67).

Moreover, the transactions at issue in this case involve a tax abuse that was not present in Compaq and IES. AIG's transactions relied on a disparity between U.S. and foreign tax laws, such that the United States and the foreign jurisdiction each treated their respective taxpayers as owning the SPV stock and permitted both parties to claim tax benefits from a single tax payment. The foreign lenders shifted their tax liability to the SPV but were credited with paying the foreign taxes by the foreign jurisdiction, while AIG claimed entirely duplicative credits in the U.S. for the same tax payments. This allowed AIG to manufacture U.S. tax benefits from "thin air." Kerman v. Comm'r, 713 F.3d 849, 864 (6th Cir. 2013)(one of the "hallmark[s]" of a sham transaction "is that the claimed tax benefit, rather than having economic substance, is seemingly created from thin air" (quotation marks omitted)). This deliberate cross-border tax avoidance simply did not exist in Compaq and IES, where there was no foreign counterparty.

The rulings in Compaq and IES are inapposite here for an additional reason. In holding that the foreign withholding tax paid on the dividends in Compaq and IES could be viewed as pre-tax income and not an expense, the courts reasoned that the taxpayer had a legal right to the gross dividend income on the ADRs they had purchased. Compaq, 277 F.3d at 783; IES, 253 F.3d at 354 (citing Old Colony Trust Co. v. Comm'r, 279 U.S. 716, 729 (1929)). In this case, by contrast, AIG cannot claim a similar legal entitlement: as a shareholder of the SPVs, AIG did not have a legal right to all of the SPVs' income, but only to distributions of earnings and profits remaining after the SPVs had paid their own income taxes.

Finally, to the extent AIG relies on Compaq or IES for the proposition that foreign tax should be excluded as an expense when analyzing profitability under the economic substance doctrine (Br. 10), that position is incorrect as a matter of economics. (JA 2362 (Dr. Cragg's calculations indicate that AIG's profits are negative when foreign tax is treated as an expense)).

In both cases, the taxpayer's "pre-tax" profit was attributable entirely to its ability to make use of foreign tax credits: it purchased the right to receive a dividend at 85% of the value of that dividend, received 85% of the dividend in cash (after the foreign tax was paid), which produced an economic wash, but additionally received foreign tax credits in the amount of 15% of the dividend, which produced its tax profit. Such a transaction has no economic substance and no purpose or utility apart from the tax consequences. But by treating the taxpayers as having benefited by 100% of the dividend rather than 85%, the Compaq and IES courts failed to recognize this economic fact. For these reasons and others, commentators, including the "preeminent authority" cited by AIG (Br. 25), have explained that Compaq and IES were wrongly decided.¹⁶

Dated: New York, New York

² The parties entered into the transactions through various subsidiaries and affiliate companies. (JA 21-40).

³ Detailed diagrams of each transaction are found at JA 1417-22.

⁴ In a prior iteration of the transaction, AIG's own counsel noted that the structure "shift[s] to the [SPV] a significant amount of liability for French income tax that would otherwise be imposed" on the foreign counterparty. (JA 2875).

⁵ On average, approximately 35% of the SPVs' capital was contributed by AIG. (JA 2362).

⁶ Before the district court, AIG argued that the domestic affiliate transactions were not material to resolution of its motion for partial summary judgment on the "borrowing" transactions. (JA 5001). Over the objection of the government, the district court ordered the parties not to address the domestic transactions in their motion papers. (JA 5007-08). Those transactions are thus irrelevant to this appeal.

⁷ AIG's statement of the standard of review characterizes the issues before the Court as purely legal ones. (Br. 20). While it is true that whether summary judgment was properly granted or denied is a question of law reviewed de novo, AIG's formulation disregards the procedural posture of this case. The ultimate question on this appeal is whether the district court correctly denied summary judgment.

⁸ The economic substance doctrine is described in more detail infra at 33-35.

⁹ Similarly, the Joint Committee on Taxation stated that "in certain situations, cross-crediting" of foreign tax credits to apply to unrelated tax liabilities "should not be permitted when it would distort the purpose of the foreign tax credit limitation." Staff of Jt. Comm. of Tax'n, 99th Cong., General Explanation of the Tax Reform Act of 1986 at 862 (1987).

¹⁰Sacks v. Comm'r, cited by AIG (Br. 22), is even further afield. In that case, after recognizing that the taxpayer's "potential for upside gain" showed economic substance, the court observed that Congress had created a tax benefit to encourage the types of investments at issue. 69 F.3d 982, 991-92 (9th Cir. 1995). Thus, the case was not about whether the economic substance doctrine should "supplant" the statute (Br. 22); it was whether Congress intended to encourage transactions that, absent tax incentives, might lose money.

¹¹ Indeed, in 2006, the Commissioner of Internal Revenue testified before the Senate Finance Committee regarding the IRS's efforts to combat "abusive foreign tax credit transactions" by applying the "economic substance" and other anti-abuse doctrines. Written Testimony of Comm'r Mark Everson on Compliance Concerns Relative to Large & Mid-Size Businesses, 2006 Tax Notes Today 114-9 (June 13, 2006).

¹² When it codified the economic substance doctrine in 2010, Congress required the taxpayer to satisfy both prongs of the analysis. See 26 U.S.C. § 7701(o)(1).

¹³ This description by one of AIG's counterparties belies AIG's suggestion that the purpose of the deals, from AIG's standpoint, was simply for AIG to "borrow" funds from the foreign banks at a below-market interest rate. Br. 9-10.

¹⁴ To the extent the district court suggested otherwise in stating that AIG would be entitled to summary judgment if its pre-tax profit calculation were correct (SPA 11), it erred. The district court noted that this Court had opined that "greater weight is given to objective facts than to the taxpayer's mere statement of intent." Lee, 155 F.3d at 586. But Lee did not hold that proof of a pre-tax profit relieves the taxpayer of the burden to demonstrate a legitimate non-tax business purpose for engaging in the activity.

¹⁵ For example, in Compaq, the taxpayer contended that it had earned a "pre-tax" profit of approximately $2 million -- i.e., the amount received from the sale of the ADRs ($868.4 million) and the gross dividend ($22.5 million), less the amount it paid for the ADRs ($887.5 million) and transaction costs ($1.4 million), even though the taxpayer received the dividend net of withholding tax ($19.1 million), so that the taxpayer had an out-of-pocket economic loss. Compaq, 113 T.C. at 221.

¹⁶See Gray Jennings, Economic Substance and the Taxpayer's Purpose, Tax Notes, vol. 27 no. 5 at 535 (May 3, 2010) (Compaq and IES transaction lacked economic substance because there was no purpose, substance, or utility apart from anticipated tax consequences); Michael S. Knoll, Compaq Redux: Implicit Taxes and the Question of Pretax Profit, 26 Va. Tax Rev. 821, 842-846 (2007) (Compaq and IES transactions would not have had economic substance if negative implicit taxes were included in the pre-tax profit calculation); Mitchell Kane, Compaq and IES: Putting the Tax Back into After-Tax Income, 94 Tax Notes 1215 (Mar. 5, 2002) (focus should be on whether taxpayer's after-tax profit was composed of tax savings); Martin J. McMahon, Economic Substance, Purposive Activity and Corporate Tax Shelters, 94 Tax Notes 1017 (Feb. 26, 2002); Daniel N. Shaviro and David A. Weisbach, The Fifth Circuit Gets It Wrong in Compaq v. Commissioner, 94 Tax Notes 511(Jan. 29, 2002); Bittker & Lokken, Federal Taxation of Income, Estates & Gifts ¶ 72.5.3 (rev. 3d ed. 2005).