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Bank Seeks Reversal of Decision Disallowing Foreign Tax Credits

MAY 12, 2014

Salem Financial Inc. v. United States

DATED MAY 12, 2014
DOCUMENT ATTRIBUTES

Salem Financial Inc. v. United States

[Editor's Note: For the full brief, including an addendum, see .]

 

UNITED STATES COURT OF APPEALS

 

FOR THE FEDERAL CIRCUIT

 

 

Appeal from United States Court of Federal Claims

 

in Case No. 10-192T, Judge Thomas Wheeler

 

 

APPEAL BRIEF OF PLAINTIFF-APPELLANT

 

SALEM FINANCIAL, INC.

 

 

Raj Madan

 

Christopher Bowers

 

Royce Tidwell

 

Bingham Mccutchen LLP

 

2020 K Street NW

 

Washington, D.C. 20006

 

(202)373-6000

 

 

                       TABLE OF CONTENTS

 

 

 TABLE OF ABBREVIATIONS

 

 

 STATEMENT OF RELATED CASES

 

 

 STATEMENT OF JURISDICTION

 

 

 STATEMENT OF THE ISSUES

 

 

 INTRODUCTION

 

 

 STATEMENT OF THE CASE AND RELEVANT FACTS

 

 

      I. The STARS Transaction Satisfied BB&T's Substantial Funding Need

 

 

      II. Barclays' U.K. Tax Treatment

 

 

      III. BB&T's U.S. Tax Treatment

 

 

      IV. The Trial Court Rejected BB&T's Tax Credits Without

 

          Considering Section 901 Or a Controlling Tax Treaty

 

 

 SUMMARY OF THE ARGUMENT

 

 

 ARGUMENT

 

 

 I. Standard of Review

 

 

 II. The Trial Court Committed Legal Error by Disregarding the Bx Payments

 

 

      A. Barclays Did Not in Substance Receive a Rebate from the

 

         U.K. Exchequer

 

 

      B. This Court's Precedent Precludes Any Indirect Rebate Analysis

 

         Outside of Section 901(i)

 

 

      C. The Bx Payments Cannot Be Rebates Under the Facts

 

 

      D. The Bx Payments Are Economic Income

 

 

           1. Payments Reimbursing Tax Costs Are Not Tax Effects

 

 

           2. Private-Party Payments Calculated by Reference to Tax

 

              Benefits Are Not Tax Effects

 

 

           3. Other Case Law Is Inapt

 

 

 III. The Trial Court Committed Legal Error by Disregarding the U.K.

 

      Tax Lawfully Imposed on the Trust's Income

 

 

 IV. Non-Tax Business Purposes Motivated the Trust Transaction

 

 

 V. BB&T Must Be Allowed to Claim at Least Forty-Nine Percent of the

 

    Foreign Tax Credits Under the Trial Court's Flawed Reasoning

 

 

 VI. BB&T Is Entitled To Claim Interest Expense Deductions

 

 

 VII. BB&T Is Not Liable for Accuracy-Related Penalties

 

 

      A. BB&T's Reliance on Sidley Established Reasonable Cause

 

 

      B. BB&T's Reliance on PwC Established Reasonable Cause

 

 

 CONCLUSION

 

 

 ADDENDUM

 

 

 CERTIFICATE OF SERVICE

 

 

 CERTIFICATE OF COMPLIANCE

 

 

 TABLE OF AUTHORITIES

 

 

 FEDERAL CASES

 

 

 ACM P'ship v. Comm'r, 157 F.3d 231 (3d Cir. 1998)

 

 

 Alpha I, LP v. United States, 93 Fed. Cl. 280 (2010)

 

 

 Am. Boat Co. v. United States, 583 F.3d 471 (7th Cir. 2009)

 

 

 Am. Elec. Power Co. v. United States, 326 F.3d 737 (6th Cir. 2003)

 

 

 Amoco Corp. v. United States, 138 F.3d 1139 (7th Cir. 1998)

 

 

 Bank of N.Y. Mellon Corp. v. Comm'r, (BNY I) 140 T.C. 15 (2013)

 

 

 Bank of N.Y. Mellon Corp. v. Comm'r, (BNY II) T.C. Memo. 2013-225

 

 

 Bankers Trust N.Y. Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000)

 

 

 Benz v. Compania Naviera Hidalgo, S.A., 353 U.S. 138 (1957)

 

 

 Biddle v. Comm'r, 302 U.S. 573 (1938)

 

 

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

 

 

 Centex Corp. v. United States, 49 Fed. Cl. 691 (2001)

 

 

 Chicago, Burlington & Quincy R.R. Co. v. United States, 455 F.

 

 2d 993 (Ct. Cl. 1972), rev'd on other grounds, 412 U.S. 401 (1973)

 

 

 Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006)

 

 

 Compaq Computer Corp. v. Comm'r, 113 T.C. 363 (1999)

 

 

 Compaq Computer Corp. v. Comm'r, 113 T.C. 214 (1999),

 

 rev'd, 277 F.3d 778 (5th Cir. 2001)

 

 

 Compaq Computer Corp. v. Comm'r, 277 F.3d 778 (5th Cir. 2001)

 

 

 Consol. Edison Co. of N.Y., Inc. v. United States, 703 F.3d

 

 1367 (Fed. Cir. 2013)

 

 

 Cont'l Ill. Corp. v. Comm'r, 998 F.2d 513 (7th Cir. 1993)

 

 

 Coors v. United States, 572 F.2d 826 (Ct. Cl. 1978)

 

 

 Diedrich v. Comm'r, 457 U.S. 191 (1982)

 

 

 Doyon Ltd. v. United States, 37 Fed. Cl. 10 (1996), rev'd

 

 on other grounds, 214 F.3d 1309 (Fed. Cir. 2000)

 

 

 Falconwood Corp. v. United States, 422 F.3d 1339 (Fed. Cir. 2005)

 

 

 Goldstein v. Comm'r, 364 F.2d 734 (2d Cir. 1966)

 

 

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

 

 

 Guardian Indus. Corp. v. United States, 477 F.3d 1368 (Fed. Cir. 2007)

 

 

 Horn v. Comm'r, 968 F.2d 1229 (D.C. Cir. 1992)

 

 

 IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001)

 

 

 Jade Trading LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010)

 

 

 King Enters., Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969)

 

 

 Kiobel v. Royal Dutch Petroleum Co., 133 S. Ct. 1659 (2013)

 

 

 Lang v. Comm'r, 100 T.C.M. (CCH) 603 (2010)

 

 

 Lee v. Comm'r, 155 F.3d 584 (2d Cir. 1998)

 

 

 N. Ind. Pub. Serv. Co. v. Comm'r, 105 T.C. 341 (1995),

 

 aff'd, 115 F.3d 506 (7th Cir. 1997)

 

 

 Norwest Corp. v. Comm'r, 69 F.3d 1404 (8th Cir. 1995)

 

 

 Old Colony Trust Co. v. Comm'r, 279 U.S. 716 (1929)

 

 

 Pepsico P.R., Inc. v. Comm'r, 104 T.C.M. (CCH) 322 (2012)

 

 

 Pullman-Standard v. Swint, 456 U.S. 273 (1982)

 

 

 Riggs Nat'l Corp. v. Comm'r, 163 F.3d 1363 (D.C. Cir. 1999)

 

 

 Rothschild v. United States, 407 F.2d 404 (Ct. Cl. 1969)

 

 

 Santander Holdings USA, Inc. v. United States, No. 1:09-cv-

 

 11043, 2013 WL 5651414 (D. Mass. Oct. 17, 2013)

 

 

 Schering Corp. v. Comm'r, 69 T.C. 579 (1978), acq.

 

 1981-2 C.B. 1

 

 

 Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219

 

 (D.N.J. 2009), aff'd sub nom. Merck & Co. v. United

 

 States, 652 F.3d 475 (3d Cir. 2011)

 

 

 Stewart v. Commissioner, 58 T.C.M. (CCH) 152 (1989)

 

 

 Stobie Creek Invs. LLC v. United States, 608 F.3d 1366 (Fed.

 

 Cir. 2010)

 

 

 Uniroyal Inc. v. Comm'r, 65 T.C.M. (CCH) 2690 (1993)

 

 

 United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014

 

 (11th Cir. 2001)

 

 

 United States v. Boyle, 469 U.S. 241 (1985)

 

 

 Voda v. Cordis Corp., 476 F.3d 887 (Fed. Cir. 2007)

 

 

 Wells Fargo & Co. v. United States, 91 Fed. Cl. 35 (2010),

 

 aff'd on other grounds, 641 F.3d 1319 (Fed. Cir. 2011)

 

 

 Wells Fargo & Co. v. United States, 641 F.3d 1319 (Fed. Cir. 2011)

 

 

 Winn-Dixie Stores, Inc. v. Comm'r, 113 T.C. 254 (1999),

 

 aff'd, 254 F.3d 1313 (11th Cir. 2001)

 

 

 Xerox Corp. v. United States, 41 F.3d 647 (Fed. Cir. 1994)

 

 

 STATUTES, REGULATIONS & TREATIES

 

 

 26 U.S.C. § 27

 

 

 26 U.S.C. § 162

 

 

 26 U.S.C. § 163

 

 

 26 U.S.C. § 901

 

 

 26 U.S.C. § 904

 

 

 26 U.S.C. § 905

 

 

 26 U.S.C. § 6662

 

 

 26 U.S.C. § 6664

 

 

 26 U.S.C. § 7422

 

 

 28 U.S.C. § 1295

 

 

 28 U.S.C. § 1491

 

 

 Treas. Reg. § 1.6664-4

 

 

 Treas. Reg. § 1.901-2

 

 

 Treas. Reg. § 1.901-2A

 

 

 Treas. Reg. § 1.904-6

 

 

 Treas. Reg. § 301.7701-3

 

 

      Convention Between the Government of the United States of

 

      America and the Government of the United Kingdom of Great

 

      Britain and Northern Ireland for the Avoidance of Double

 

      Taxation and the Prevention of Fiscal Evasion with Respect to

 

      Taxes on Income and on Capital Gains, July 24, 2001, 2224

 

      U.N.T.S. 247

 

 

 Dep't of Treasury, Technical Explanation of the 2001 U.S.-U.K.

 

 Treaty, July 19, 2002

 

 

 Exchange of Notes to arts. 1(8) and 24 of the Treaty (July 24, 2001)

 

 

 LEGISLATIVE MATERIALS

 

 

 H.R. Rep. No. 99-426 (1985)

 

 

 H.R. Rep. No. 108-755 (2004) (Conf. Rep.)

 

 

      Staff of J. Comm. on Tax'n, 110th Cong., Description of the

 

      Chairman's Amendment in the Nature of a Substitute of H.R. 3996,

 

      the "Temporary Tax Relief Act of 2007," JCX-106-07,

 

      available at

 

      https://www.jct.gov/publications.html?func=showdown&id=1358

 

 

 ADMINISTRATIVE MATERIALS

 

 

 I.R.S. Chief Couns. Adv. 2002-23-022 (Mar. 1, 2002)

 

 

 I.R.S. Chief Couns. Adv. 2005-32-044 (May 5, 2005)

 

 

 I.R.S. Chief Couns. Adv. 2013-49-015 (Sept. 16, 2013)

 

 

 I.R.S. Field Serv. Adv. 003803 (June 3, 1996) (updated on Jan. 31, 2006)

 

 

 I.R.S. Field Serv. Adv., 1998 FSA Lexis 153 (Aug. 21, 1998)

 

 

 I.R.S. Field Serv. Adv. 2001-39-008 (May 15, 2001)

 

 

 I.R.S. Gen. Couns. Mem. 34,109 (Apr. 25, 1969)

 

 

 I.R.S. Gen. Couns. Mem. 35,220 (Jan. 30, 1973).

 

 

 I.R.S. Gen. Couns. Mem. 38,467 (Aug. 11, 1980)

 

 

 I.R.S. Priv. Ltr. Rul. 5812056040A (Dec. 5, 1958).

 

 

 I.R.S. Priv. Ltr. Rul. 7609101040A (Sept. 10, 1976)

 

 

 I.R.S. Priv. Ltr. Rul. 87-42-010 (July 10, 1987)

 

 

 I.R.S. Priv. Ltr. Rul. 2009-51-024 (Sept. 1, 2009)

 

 

 I.R.S. Tech. Adv. Mem. 78-40-001 (Sept. 15, 1977)

 

 

 I.R.S. Tech. Adv. Mem. 98-21-003 (Feb. 9, 1998)

 

 

 Rev. Rul. 54-15, 1954-1 C.B. 129

 

 

 Rev. Rul. 79-289, 1979-2 C.B. 145

 

 

 Rev. Rul. 83-142, 1983-2 C.B. 68

 

 

 T.D. 8372, 1991-2 C.B. 338

 

 

 OTHER AUTHORITIES

 

 

 AU Section 9326 -- Auditing Interpretations of Section 326,

 

 available at

 

 http://pcaobus.org/Standards/Auditing/Pages/AU9326_22.aspx

 

 

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

 

 Amok, 71 Tax Notes Int'l (TA) 831 (Aug. 26, 2013)

 

 

 Victor Fleischer & Nancy Staudt, The Supercharged IPO, 67

 

 Vand. L. Rev. 307 (2014)

 

 

 Elisabeth A. Owens, The Foreign Tax Credit (1961)

 

 

 OTHER CASE FILINGS

 

 

 Ruling on Motion for Imposition of the Neglilgence Penalty,

 

 TIFD III-E, INC. v. United States, Nos. 01-cv-1839, 01-

 

 cv-1840, 2014 WL 1274052 (D. Conn. Mar. 28, 2014)

 

 

 United States Opening Post-Trial Br., Consol. Edison Co. of

 

 N.Y., Inc. v. United States, 90 Fed. Cl. 228 (2009) (No.

 

 06-305T), ECF No. 99

 

 

                             TABLE OF ABBREVIATIONS

 

 ______________________________________________________________________________

 

 

 Abbreviation                            Meaning

 

 ______________________________________________________________________________

 

 

 "Appellee" or "Government"              United States of America

 

 

 "Appellant" or "BB&T"                   Branch Bank & Trust Co. and/or

 

 

                                         Salem Financial, Inc. (a wholly

 

                                         owned subsidiary of Branch Bank

 

                                         & Trust Co.)

 

 

 "Barclays"                              Barclays Bank PLC

 

 

 "Bx Payments"                           Monthly payments from Barclays

 

 to BB&T

 

 

 "Code"                                  Title 26 of the U.S. Code --

 

                                         i.e., the Internal Revenue

 

                                         Code of 1986

 

 

 "Delco"                                 Subsidiary of the Trust that held

 

                                         income-producing assets

 

 

 "KPMG"                                  KPMG LLP

 

 

 "Loan"                                  The financing component of STARS

 

 

 "PwC"                                   PricewaterhouseCoopers LLP

 

 

 "Section"                               Reference to section of the Code

 

 

 "Sidley"                                Sidley Austin Brown & Wood LLP

 

 

 "STARS"                                 Structured Trust Advantaged

 

                                         Repackaged Securities, the

 

                                         transaction between BB&T and

 

                                         Barclays at issue in this appeal

 

 

 "Trust"                                 Entity in STARS that earned

 

                                         income taxable in the United

 

                                         Kingdom

 

 

 "Trust Transaction"                     The portion of STARS other than

 

                                         the Loan

 

 

 "Treaty"                                Convention Between the

 

                                         Government of the United States

 

                                         of America and the Government of

 

                                         the United Kingdom of Great

 

                                         Britain and Northern Ireland for

 

                                         the Avoidance of Double Taxation

 

                                         and the Prevention of Fiscal

 

                                         Evasion with Respect to Taxes on

 

                                         Income and on Capital Gains, July

 

                                         24, 2001, 2224 U.N.T.S. 247

 

STATEMENT OF RELATED CASES

 

 

Counsel knows of no case related to this one pursuant to Circuit Rule 47.5. Four pending unrelated cases present nearly identical issues:
  • Santander Holdings USA, Inc. v. United States, No. 1:09-cv-11043 (D. Mass.).

  • Bank of New York Mellon Corp. v. Commissioner of Internal Revenue, No. 14-704 (2d Cir.).

  • Wells Fargo & Co. v. United States, No. 0:09-cv-02674-PJS-TNL (D. Minn.).

  • Am. Int'l Group v. United States, No. 1:09-cv-01871-LLS (S.D.N.Y.).

STATEMENT OF JURISDICTION

 

 

This is an appeal from a final judgment of the Court of Federal Claims adjudicating a claim for refund of taxes, interest, and penalties under 28 U.S.C. § 1491(a) and Section 7422. Final judgment was entered on October 9, 2013, (JA68), and BB&T's timely motion for reconsideration was denied on January 7, 2014, (JA70). This Court has jurisdiction under 28 U.S.C. § 1295(a)(3).

 

STATEMENT OF THE ISSUES

 

 

The trial court disallowed foreign tax credits for U.K. taxes imposed on, and paid by, BB&T with respect to a five-year, $1.5 billion financing transaction between it and Barclays. Applying judicial substance doctrines, the court held that U.K. taxes had been rebated to BB&T (via U.K. tax benefits obtained by Barclays) and were not properly imposed by the United Kingdom in the first place. The court also disallowed deductions for interest that BB&T paid on the loan and imposed penalties.

 

1. Did the trial court err by holding that BB&T's U.K. taxes were indirectly or "in substance" rebated when no party to the transaction received an actual rebate of U.K. taxes and the Government agreed that the statute determining when foreign taxes are indirectly or "in substance" rebated does not apply?

2. Did the trial court err by second-guessing the propriety of the U.K. taxes imposed on BB&T?

3. Did the trial court err in holding that the $1.5 billion loan obtained by BB&T lacked substance because it was (purportedly) relatively expensive and (purportedly) "camouflage" for U.K. tax rebates, even though BB&T had unfettered use for the $1.5 billion in its business?

4. Did the trial court err by imposing penalties and holding that BB&T lacked reasonable cause even though it relied on the advice of fifteen tax professionals from three firms and a federal district court has held that an identical transaction had economic substance?

INTRODUCTION

 

 

This case is about the U.S. tax treatment of a financing transaction known as STARS, through which BB&T borrowed $1.5 billion from Barclays for nearly five years. (JA2.) That, in turn, implicates two tax doctrines -- the economic substance and substance-over-form doctrines. These familiar doctrines are tools for fulfilling legislative intent, not invitations for ad hoc, boundless judicial or executive inquiry into the substance of a transaction. Three courts have analyzed STARS transactions and reached different decisions about its tax treatment even though, as the Government contended, (JA49013; JA49039), and the trial court held, (JA12), all three were virtually identical. For the most part, the divergence owes to the courts' conflicting approaches to judicial substance doctrines.

Only one court got it right. In Santander Holdings USA, Inc. v. United States, No. 1:09-cv-11043, 2013 WL 5651414 (D. Mass. Oct. 17,2013), the District of Massachusetts applied judicial substance doctrines consistent with the underlying foreign tax credit rules and related case law. The Santander court declined to apply judicial substance doctrines contrary to that law to reach the "possibly outcome-driven" result the Government demanded. Id. at *6. Rather, the Santander court recognized that the Code and regulations already address the Government's concerns regarding the foreign tax credits claimed with respect to STARS, including concerns about "'constructive' or 'effective' rebates" of foreign taxes. The Santander court correctly held that the Trust Transaction generated no "improper tax benefit." Id. at *7.

In Bank of New York Mellon Corp. v. Comm'r ("BNY I"), 140 T.C. 15 (2013), the Tax Court reached a contrary conclusion because it applied judicial substance doctrines without analyzing the underlying law of foreign tax credits. This critical error led it to hold that the Trust Transaction lacked economic substance. Id. at 31, 48. Yet, even under that flawed approach to judicial substance doctrines, the Tax Court correctly recognized that the Loan was a substantive transaction and must be respected for tax purposes. Bank of New York Mellon Corp. v. Comm'r ("BNY II"), T.C. Memo. 2013-225 at *3-*4.

In this case, the trial court followed the Tax Court's lead but went even further. Emphasizing the complexity of the transaction, (JA1; JA27), and believing that it was "reprehensible" and "an abusive tax avoidance scheme," (JA3), the trial court wielded judicial substance doctrines without any attention to the underlying law. In holding that payments from Barclays to BB&T (known as Bx Payments) were in substance "rebates" of BB&T's U.K. taxes, the trial court did not mention the statutes, regulations, and cases that already determine whether a payment of foreign taxes is in substance a "rebate." (JA54.) The trial court even went as far as rejecting the United Kingdom's sovereign decision to impose income tax in the first place. (See JA54; JA59-60.) In the end, the trial court rejected not only the Trust Transaction as lacking substance, but the Loan as well, (JA56), and imposed penalties, (JA60).

The trial court committed legal error in its unbounded deployment of judicial substance doctrines. Foreign tax credits are available under Sections 27 and 901, which prevent double taxation by reducing dollar-for-dollar the federal income tax imposed on income taxed by a foreign jurisdiction. See Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932) ("[T]he primary design of the provision [the predecessor to Section 901] was to mitigate the evil of double taxation."). Foreign tax credits implicate sensitive issues of foreign affairs -- such as the tax regimes of foreign sovereigns and how our Government, our residents, and our tax system interact with them. Given that sensitivity, Congress and the Government have created a precise and detailed regime that directs courts and taxpayers how to determine the substance of a foreign tax payment. That regime necessarily sets boundaries on the application of judicial substance doctrines.

In this case, the Government repudiated that regime in favor of an unbounded application of judicial substance doctrines.1 But "Treasury cannot with one hand promulgate . . . regulations that have the force and effect of statutory law, and, with the other, require a taxpayer under the guise of [a substance] doctrine to proceed contrary to the regulations but only when to the government's benefit." Falconwood Corp. v. United States, 422 F.3d 1339, 1352 n.6 (Fed. Cir. 2005). The trial court's acquiescence failed to "effectuat[e] the underlying Congressional purpose" of the foreign tax credit laws, Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1354 (Fed. Cir. 2006), and instead "preempt[ed] congressional intent" beyond the proper function of judicial substance doctrines. Horn v. Comm'r, 968 F.2d 1229, 1236 (D.C. Cir. 1992).

This is not to say that literal compliance with a statute is sufficient to claim a credit or deduction, or that judicial substance doctrines cannot apply to foreign tax credits. The sole purpose of judicial substance doctrines, however, is to advance congressional intent by filling gaps in statutes. (See JA50-52; JA50061.) Judicial doctrines cannot be used to contradict congressional intent.

As the Santander court recognized, the "understandable instinctive reaction [to the complexity of STARS] is not a substitute for careful analysis, and on careful analysis, the government's position does not hold up." Santander, 2013 WL 5651414, at *1. This Court should reach the same conclusion and reverse the trial court's judgment.

 

STATEMENT OF THE CASE AND RELEVANT FACTS

 

 

I. THE STARS TRANSACTION SATISFIED BB&T'S SUBSTANTIAL FUNDING

 

NEED

 

 

In 2002, BB&T had a substantial funding need, which it satisfied by borrowing $1.5 billion from Barclays through STARS. (JA280; JA196; JA21346; JA16323.) The STARS financing benefitted BB&T in many ways: diversifying its funding base, (JA25634; JA25636; JA110); reducing liquidity risk, (JA295); and permitting as collateral assets not accepted by its other lenders, (JA282; JA118).

The net cost of the STARS funding was well below BB&T's normal cost of funds because, as part of the transaction, Barclays provided BB&T monthly payments -- the Bx Payments -- that offset interest owed on the loan. (JA11723-24.) Barclays was willing to make these payments because it expected to receive U.K. tax benefits (described below) from the STARS structure. (See JA2.) Barclays calculated the amount of the Bx Payments by reference to the U.K. tax credits it anticipated. (JA15012.)

To receive the Loan, Barclays required BB&T to place assets in a Trust that was a resident of the United Kingdom. (JA318; JA3543.) The income from these assets was taxed twice -- once by the United Kingdom because the Trust resided there for U.K. tax purposes, (JA30), and again by the United States because the Trust's income flowed through to BB&T for U.S. tax purposes, (see JA49; JA26592).

To accomplish Barclays' U.K. tax objectives, which required a number of entities and cash flows, (JA27-38), the overall structure of STARS was "unusually complex," (JA1). The details of the STARS structure, however, are largely not pertinent to this appeal and are generally undisputed. (JA47275-88.) The central question presented by this appeal is whether BB&T may eliminate its double taxation, which in turn raises the question whether judicial substance doctrines may be applied to disregard three aspects of the STARS transaction -- the $1.5 billion loan, BB&T's payment of U.K. tax, and the Bx Payments. With that in mind, the core elements of the transaction can be simplified as follows:

  • BB&T contributed about $6 billion of income-producing assets to the Trust and Delco. (JA28-29.) About $1.5 billion was collateral for BB&T's borrowing from Barclays. (JA29.) The Trust was taxed by the United Kingdom on the income from these assets, which it timely satisfied in cash. (JA33.)

  • Barclays extended financing to BB&T by acquiring an interest in the Trust for $1.5 billion. (JA29.) BB&T was obligated to repurchase Barclays' Trust interest and thereby repay the Loan. (JA30.) BB&T paid Barclays interest on the $1.5 billion at a rate of LIBOR + 25 basis points. (JA31.)

  • BB&T also received Bx Payments from BB&T. (JA36.) The parties negotiated the Bx Payments in advance, formally setting the amounts equal to approximately 51 percent of the U.K. tax credit Barclays expected to receive (but without regard to the two U.K. deductions Barclays expected to take). (JA37.)

  • During the term of STARS, Delco made monthly distributions of cash to the Trust and received monthly re-investments of that cash (net of U.K. taxes owed and minor distributions made on other interests in the Trust). (JA31-32.) Barclays received monthly distributions of cash from the Trust and then re-contributed the cash to the Trust. (Id.) Without these distributions and re-contributions, Barclays could not claim a portion of its U.K. tax benefits. (See JA38-39.)

II. BARCLAYS' U.K. TAX TREATMENT

 

 

For U.K. tax purposes, the legal form of the transaction was respected. (See JA38-39.) Barclays was treated as purchasing and holding an ownership interest in the Trust, receiving cash distributions, and re-contributing the cash for additional ownership interests. (JA38.) The Trust and Delco were respected as separate entities, and distributions and re-contributions of cash between them were respected. (See JA704.) As illustrated below, the purported "circular cash flows" identified by the trial court were also respected for U.K. tax purposes and taxed accordingly.

 

Illustration A: STARS Ownership for U.K. Tax Purposes

 

 

 

 

Illustration B: STARS Income for U.K. Tax Purposes

 

 

 

 

Barclays' U.K. tax treatment can be understood with a straightforward example in which the Trust receives $100 of income. (JA38-39.) Barclays was subject to $30 of U.K. corporation tax on the distributions it received from the Trust. (JA38.) This tax liability was offset by three tax attributes: (i) a $22 credit for taxes paid by the Trust, thus preventing double taxation by the United Kingdom; (ii) a $23.40 trading loss deduction realized on the re-contribution of cash to the Trust; and (iii) a $3.30 deduction for the Bx Payments. (JA38.) The net result was a tax benefit that Barclays used to reduce U.K. tax on unrelated income. (See, e.g., JA44458.) Neither the Trust nor Barclays ever received a cash payment or any refund from the U.K. Exchequer for the Trust's U.K. taxes. (JA47292.)

 

III. BB&T'S U.S. TAX TREATMENT

 

 

Unlike the form-driven U.K. tax treatment of STARS, BB&T reported the transaction on its U.S. federal income tax returns in accordance with its substance -- i.e., as a borrowing secured by assets -- as required under U.S. tax law. (JA504.) The core entities recognized for U.K. tax purposes, including the Trust and Delco, were either flow-through entities (i.e., partnerships in which the partners, but not the partnerships, were subject to tax on the partnerships' income) or were disregarded for U.S. tax purposes.2 (JA49641.) Similarly, the cash flows between the Trust and Delco and between the Trust and Barclays -- cash flows the trial court described as "circular" -- were either affirmatively ignored by BB&T for U.S. tax purposes or gave rise to no independent U.S. tax consequences. (JA49641.) BB&T was treated as directly earning the income generated by the assets held by the Trust and Delco. Accordingly, in stark contrast to how the STARS transaction was viewed for U.K. tax purposes, the transaction was viewed as follows for U.S. tax purposes:

 

Illustration C: STARS Ownership for U.S. Tax Purposes

 

 

 

 

Illustration D: STARS Income for U.S. Tax Purposes

 

 

 

 

BB&T recognized the income generated by the assets held in the STARS transaction for U.S. tax purposes. (See JA49; JA26592.) That income was subject to both U.K. and U.S. tax. BB&T's U.S. tax liability from the STARS transaction was partially offset by credits and deductions claimed as follows:
  • BB&T claimed foreign tax credits under Section 901 for taxes paid to the United Kingdom, partially offsetting the U.S. tax imposed on the income from the Trust's assets. (See JA2.) BB&T's income and total tax liability before and after the STARS transaction are summarized as follows:

 

     Asset Income and Taxes              Asset Income and Taxes

 

     Pre-STARS                           Post-STARS

 

 ______________________________________________________________________

 

 

 $100 of Asset Income                    $100 of Asset Income

 

 ($35 of U.S. Tax)                       ($22 of U.K. Tax)

 

                                         ($35 of U.S. Tax)

 

                                         $22 U.S. Foreign Tax Credit

 

                                         ($35 of Total Tax)

 

 

 $65 of Net Income from Assets           $65 of Net Income from Assets

 

  • BB&T claimed deductions for interest expense (as reduced by the Bx Payments, thereby including them in income) under Section 163. (JA2.)

  • BB&T claimed deductions for transaction costs under Section 162. (Id.)

 

Before executing STARS, BB&T received tax advice from three firms that analyzed the proper tax treatment of the transaction and concurred with BB&T's tax reporting. Relevant details of that tax advice are discussed in Part VII, infra.

 

IV. THE TRIAL COURT REJECTED BB&T'S TAX CREDITS WITHOUT

 

Considering Section 901 Or a Controlling Tax Treaty

 

 

The trial court ruled that BB&T was not entitled to foreign tax credits or deductions. (JA56.) The court began by separating STARS into two separate components: (i) the "Trust Transaction" -- the elements of the transaction (including the Bx Payments) other than the loan, and (ii) the STARS "Loan" -- the $1.5 billion loan to BB&T at an interest rate of LIBOR + 25 basis points. (JA53.)3 The trial court then applied two judicial substance doctrines to the two halves of STARS. Id.

The trial court held that the foreign tax credits BB&T claimed in connection with the Trust Transaction should be denied. (JA56.) According to the court, the Trust Transaction "consisted of three principal circular flows," one of which was the combination of BB&T's payment of U.K. tax, Barclays' receipt of U.K. tax benefits, and the Bx Payments. (JA54.) Variously calling the Bx Payments reimbursements, rebates, or returns of BB&T's foreign tax payments, the trial court concluded that the receipt of the Bx Payments permitted BB&T to claim a foreign tax credit "for a U.K. tax cost that it had not in substance paid." (JA55.) The trial court held that the Trust Transaction was a sham because, in its view, the Bx Payments were "tax effects" that should be ignored in determining pre-tax profit. (JA56.) Going even further, the trial court held that BB&T did not engage in sufficient U.K. activity through the Trust Transaction to warrant the imposition of U.K. tax in the first place. (JA59-60.)

Then, the trial court held that BB&T could not claim interest deductions, holding that the Loan had no non-tax business purpose and had no possibility of pre-tax profit. Supposedly, the Loan was relatively expensive and designed solely to "camouflage" the Bx Payments. (JA56.)

Finally, the trial court held that BB&T was liable for penalties under Section 6662 on the basis of both negligence and a substantial understatement of tax. (JA67.)

 

SUMMARY OF THE ARGUMENT

 

 

For this appeal, BB&T accepts the trial court's holding that the Trust Transaction and the Loan may be bifurcated, notwithstanding that the lynchpin conclusions of the trial court supporting bifurcation -- that "the links between the Trust [Transaction] and Loan . . . are artificial" and the Loan had no purpose beyond "camouflag[ing]" the Bx Payments, (JA53; JA56) -- are wholly unsupported by the record. See infra p. 64. That error is ultimately immaterial because the court's other errors, alone, warrant reversal. Those dispositive errors stem from the trial court's legally erroneous application of two judicial substance doctrines to the Trust Transaction and the Loan.

These judicial doctrines derive from a common principle "that the substantive realities of a transaction determine its tax consequences." King Enters., Inc. v. United States, 418 F.2d 511, 516 n.6 (Ct. Cl. 1969).The economic substance doctrine, determines whether a transaction should be disregarded for tax purposes by testing whether the transaction has "economic reality" -- often by analyzing whether the taxpayer has a reasonable possibility of generating a profit apart from taxes. Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1376-77 (Fed. Cir. 2010). The substance-over-form doctrine, re-characterizes transactions when their substance or "true nature" differs from their legal form. Consol. Edison Co. of N.Y. v. United States, 703 F.3d 1367, 1374 (Fed. Cir. 2013).

The critical failure of the trial court was in performing its substance analysis in a manner that conflicts with the underlying law of foreign tax credits. Judicial substance doctrines cannot be applied by disregarding the governing statutes and regulations because the doctrines are "merely . . . judicial tool[s] for effectuating the underlying Congressional purpose." Coltec, 454 F.3d at 1354; see Consol. Edison, 703 F.3d at 1374; Gregory v. Helvering, 293 U.S. 465, 469 (1935).

 

The Trust Transaction

 

 

As a matter of law, the Bx Payments represent economic income that imbues the Trust Transaction with economic profit. Contrary to the trial court's holding, the Bx Payments are not "in substance" rebates or refunds of the BB&T's U.K. taxes. The Government expressly agreed that these taxes were not directly, indirectly, or "in substance" rebated to Barclays, BB&T, or any other party as determined by Section 901(i). Under this Court's binding case law, the Government's agreement ends any inquiry into whether the Bx Payments are a rebate of U.K. taxes.

Treated properly, the Bx Payments are private-party payments that represent pre-tax income. The Trust Transaction, then, is profitable and profit-seeking, so it satisfies the objective and subjective prongs of the economic substance test. Yet, even if the Court finds that the Bx Payments were "rebates" of BB&T's U.K. taxes, BB&T must be allowed to claim some foreign tax credits because the Bx Payments did not "rebate" all of BB&T's U.K. tax payments.

The trial court also erred by questioning the United Kingdom's imposition of income tax on the Trust's income. Second-guessing the United Kingdom is barred by the act of state doctrine, violates the Treaty that specifically recognized the United Kingdom's right to tax the Trust's income, and contradicts the Government's long-standing position that accepts disparate foreign standards for determining tax residence and taxable income for purposes of Section 901. Put simply, no judicial substance doctrine can disregard BB&T's payment of U.K. income taxes to the U.K. Exchequer.

 

The Loan

 

 

Loans from third parties that provide a borrower with funds that can be used and invested -- like the STARS Loan -- have economic substance and cannot be ignored. The trial court misapplied that principle and this Court's precedents by fixating on the interest rate (which the trial court claimed was too high) and the Loan's purported purpose (which the trial court claimed was to "camouflage" BB&T's supposed tax rebates). That was legal error.

 

PENALTIES

 

 

Negligence and substantial understatement penalties are not appropriate. Other courts have held that all, or at least part, of virtually identical STARS transactions had economic substance, so BB&T's position can hardly be deemed negligent. Moreover, the IRS chose not to assert available penalties against Bank of New York for its virtually identical STARS transaction. (See JA12.) In any event, BB&T reasonably relied upon its advisors in support of its tax position.

 

ARGUMENT

 

 

I. STANDARD OF REVIEW

 

 

This Court reviews applications of the economic-substance and substance-over-form doctrines without deference. See Coltec, 454 F.3d at 1357 (economic substance); Wells Fargo & Co. v. United States, 641 F.3d 1319, 1325 (Fed. Cir. 2011) (substance over form). This Court reviews whether a taxpayer had reasonable cause for its reporting position for clear error. See Stobie Creek, 608 F.3d at 1381-82.

 

II. THE TRIAL COURT COMMITTED LEGAL ERROR BY DISREGARDING THE BX

 

PAYMENTS

 

 

The trial court held that the Trust Transaction was not profitable, relying entirely on its conclusion that the Bx Payments were not pre-tax income. According to the trial court, "[t]he economic nature of the Bx payments simply is a tax effect" because the Bx Payments were "in substance a rebate of [BB&T's] U.K. tax payments." (JA55.)

Special rules under Section 901 govern when a taxpayer receives or is expected to receive an actual rebate of foreign taxes. See Section 905(c); Treas. Reg. § 1.901-2(e)(2). It is undisputed that neither BB&T nor the Trust received an actual rebate in fact or under these rules. (See JA43553.)

In concluding that BB&T received an effective or economic rebate, the trial court relied upon the testimony of the Government's economic experts, summarized below in one of their trial demonstratives:

 

 

 

(JA47.) The trial court concluded that, through the Trust Transaction, "BB&T cycled tax through the U.K. taxing authority, then to Barclays, and then back to itself." (JA54 (emphasis added).) The court also observed that the "value of BB&T's U.K. tax payment ends up in the hands of Barclays" and that "Barclays then paid BB&T for subjecting itself to U.K. tax." (JA55.)

The trial court missed the point. As the Government's purported "economic" analysis and demonstrative acknowledge, the U.K. Exchequer and Barclays are critical links in the supposed chain of rebate payments. Barclays could not indirectly, economically, or "effectively" rebate BB&T's U.K. taxes to BB&T (via the Bx Payments) unless the U.K. Exchequer first took BB&T's U.K. taxes and then indirectly transferred them to Barclays (as a tax benefit). The question is, "[s]hould the [Bx Payments] be treated, as a matter of law, as if [they] were a rebate from the U.K. to [the U.S. bank]. That is a legal question, to be answered by judges, not economists." Santander, 2013 WL 5651414, at *4.

As a matter of law, the trial court could not characterize the Bx Payments as indirect rebates from the U.K. Exchequer to Barclays and ultimately to BB&T. By this Court's precedent -- precedent the trial court did not even acknowledge -- courts evaluating the propriety of a foreign tax credit are prohibited from examining how a foreign government uses income taxes paid by a U.S. person. Congress has provided a single exception to that prohibition. Section 901(i) defines when a tax paid by a U.S. person is in substance rebated as a tax benefit to another party. The Government agrees this statute does not apply in this case, and thus must agree that BB&T's U.K. taxes were not in substance rebated. No further analysis into the substance of the Trust Transaction is allowed. The substance of the Bx Payments and the Trust transaction does not change depending upon whether they are analyzed under the Code and regulations or judicial substance doctrines; substance is substance no matter the purpose for which it is analyzed.

A. Barclays Did Not in Substance Receive a Rebate from the U.K. Exchequer

U.S. law directly addresses what counts as a "rebate" of foreign taxes in substance. Section 901(i) provides that a foreign tax is not considered paid and hence not creditable to the extent "(1) the amount of such tax is used (directly or indirectly) by the country imposing such tax to provide a subsidy by any means to the taxpayer . . . or any party to the transaction or to a related transaction, and (2) such subsidy is determined (directly or indirectly) by reference to the amount of such tax, or the base used to compute the amount of such tax." (emphasis added). Treasury Regulation § 1.901-2(e)(3) broadly defines a "subsidy" to include "any benefit conferred, directly or indirectly, by a foreign country", id. § 1.901-2(e)(3)(ii), and lists examples of subsidies as including "a rebate, refund, a credit, a deduction, a payment, a discharge of an obligation, or any other method." Id. § 1.901-2(e)(3)(i).

Section 901(i) and the regulations require an analysis into the substance of a transaction to determine whether foreign taxes have been rebated. Congress intended that Section 901(i) would apply when a taxpayer does not receive a direct rebate or refund but instead pays foreign taxes which, "while ostensibly imposed, are effectively rebated by the levying country." H.R. Rep. No. 99-426, at 351 (1985). Similarly, the regulations expressly mandate that "[s]ubstance and not form shall govern in determining whether a subsidy exists." Treas. Reg. § 1.901-2(e)(3)(ii); see also Norwest Corp. v. Comm'r, 69 F.3d 1404, 1409 (8th Cir. 1995) (describing the Section 901(i) regulations as "reasonably interpret[ing] the statutory language 'paid or accrued' to mean circumstances in which the foreign tax . . . has in substance been paid"); Amoco Corp. v. Comm'r, 138 F.3d 1139, 1145 (7th Cir. 1998) ("[I]t is easy to envision circumstances in which a third party pays foreign tax on behalf of a U.S. taxpayer and then receives a refund of that same payment. . . . [I]t seems to us that this is precisely what the indirect subsidy rule of § 1.901-2(e)(3) was designed to cover.").

In discovery, BB&T asked the Government whether Section 901(i) and its regulations applied to the U.K. taxes BB&T paid. The Government's answer was clear: "For purposes of this litigation, the United States does not contend that U.K. income tax paid by [the Trustee of the Trust] is subject to I.R.C. § 901(i) and Treas. Reg. § 1.901-2(e)(3)." (JA43554.) The Government has never wavered from this admission, but has consistently agreed that BB&T satisfied all the requirements of Section 901. (See JA49607-14; JA49725-28; JA49884-85.)

The Government's concession that the Trust taxes were in substance paid to the U.K. Exchequer and not rebated is well grounded in Section 901(i) and U.K. law. None of the three U.K. tax "benefits" that Barclays received in the STARS transaction are a "rebate" of the Trust taxes in substance under Section 901(i). First, Barclays' deduction for the Bx Payments ($3.30 in the trial court's example) is wholly unrelated to any payment of tax and is available to any U.K. corporation that makes a payment as part of its business. A generally available deduction, unconnected to the Trust's payment of taxes, is not a rebate of any taxes, let alone the Trust's taxes. See Treas. Reg. § 1.901-2(e)(3)(iv), Examples 4 and 5. Second, Barclays' trading loss deduction ($23.40 in the trial court's example) is not a rebate. BB&T and the Government agreed that the trading loss deduction was not dependent upon, not derived from, and not even related to the payment of taxes by the Trust. (JA47347; JA50016.) Thus, the trading loss deduction cannot be an indirect rebate of the Trust taxes for purposes of Section 901(i).4

Third, the Government also properly agreed that Barclays' credit for the U.K. taxes paid by the Trust ($22 in the trial court example) is not an indirect rebate in substance under Section 901(i). (See JA38.) That credit cannot possibly be a rebate of the Trust's taxes: Barclays was entitled to the credit under U.K. law whether or not the Trust actually paid the tax. (JA724.) The credit was an "imputation credit" that partially offset a higher, second tax on the distributions received from the Trust ($30 in the trial court's example). (See JA38.) Imputation credits are not indirect rebates so long as the initial tax payment -- i.e., the Trust tax -- is retained by the foreign government (as was the case here). See I.R.S. Chief Couns. Adv. 2005-32-044 (May 5, 2005); Compaq Computer Corp. v. Comm'r, 113 T.C. 363, 374 (1999) (corporate tax offset provided to a subsidiary corporation in an imputation credit system is not a subsidy). Here, because the Trust taxes were retained by the U.K. Exchequer, the Government rightly agreed that such taxes were not indirectly, effectively, or in substance rebated under Section 901(i).5

Congress, courts, and the Government have thus defined what constitutes an indirect rebate in substance of foreign taxes and, as the Government admitted in this case, the Bx Payments are not it. While judicial doctrines certainly apply in the foreign tax credit context, they may not be applied, as they were below, in a manner that conflicts with the governing law. By agreeing that the U.K. tax paid by BB&T through the Trust satisfied Section 901(i), the Government agreed that BB&T had in substance paid such U.K. taxes, that the U.K. Exchequer had not in any manner rebated such U.K. taxes to Barclays or any other party, and that the Bx Payments could therefore not be "in substance" rebates of the Trust's taxes. The necessary link in the trial court's purported circle of tax -- the rebate of the Trust's U.K. taxes to Barclays -- simply never happened.

B. This Court's Precedent Precludes Any Indirect Rebate Analysis Outside of Section 901(i)

Once the Government agreed that the U.K. tax paid by BB&T was not an indirect rebate under Section 901(i), the inquiry into the existence of any "in substance" rebate in the STARS transaction ended. Outside of applying clear Congressional dictates like Section 901(i), federal courts refrain from inquiring into the propriety of a foreign government's actions within its own territory. See Kiobel v. Royal Dutch Petroleum Co., 133 S. Ct. 1659, 1664 (2013). Courts are not equipped to undertake inquiries that implicate foreign relations; only when federal law expressly requires such an inquiry will courts do so. See Benz v. Compania Naviera Hidalgo, S.A., 353 U.S. 138, 147 (1957) ("For us to run interference in . . . a delicate field of international relations there must be present the affirmative intention of the Congress clearly expressed.").

This Circuit's law fully accords with these principles and barred the trial court from resorting to judicial substance doctrines in this case beyond Section 901(i). In a series of cases known as the Mexican Railroad Car Cases, the predecessor to this Court rejected the Government's challenge to the creditability of Mexican taxes incurred by U.S. companies even though the taxes were, by design, rebated to Mexican railroads that had leased railway cars from the U.S. companies. See, e.g., Chicago, Burlington & Quincy R.R. Co. v. United States, 455 F.2d 993 (Ct. Cl. 1972), rev'd on other grounds, 412 U.S. 401(1973). In those cases, the court rejected the Government's claim that the U.S. companies had not paid tax to Mexico, holding instead that "[t]he fact that the Mexican Government later granted subsidies to the Mexican railroads equal to the plaintiff's tax payments does not change the fact that the plaintiff made the payments. This is wholly an internal Mexican affair that is of no concern to us." 455 F.2d at 1023 (emphasis added).

This Court reconfirmed the holding of the Mexican Railroad Car Cases in Bankers Trust N.Y. Corp. v. United States, 225 F.3d 1368 (Fed. Cir. 2000), denying the Government's challenge to a foreign tax credit claimed for a Brazilian tax on interest that was remitted to the Brazilian tax authority. In Bankers Trust, the Brazilian government transferred the taxes back to the Brazilian borrowers in a manner that was substantially the same as the Mexican government had paid a subsidy to the Mexican railroads in the Mexican Railroad Car Cases. Id.

The Government challenged the creditability of the Brazilian tax, arguing that it had not been "paid" for purposes of subsidy regulations issued prior to the enactment of Section 901(i) but upon which Section 901(i) was based and essentially codified. See Bankers Trust, 255 F.3d at 1370-71. While recognizing that the enactment of Section 901(i) left the holding in the Mexican Railroad Car Cases with "only limited vitality," this Court held that the subsidy regulations did not overrule those authorities. Id. at 1376. The Court, accordingly, applied these cases, refused to consider the "substance" of the Brazilian refund, and concluded that Bankers Trust had paid the Brazilian taxes for purposes of Section 901.

The trial court's options in this case were twofold: either hold that the U.K. Exchequer rebated BB&T's taxes to Barclays under Section 901(i) (a holding the law and the Government's concession preclude), or else refrain from analyzing the substance of Barclays' tax benefit (a result dictated by defaulting to the Mexican Railroad Car Cases as the governing law once Section 901(i) was deemed inapplicable). The trial court ignored these required paths, and instead re-examined how the U.K. government used the taxes BB&T paid to it, diving headlong into a matter it had no business considering. Cf. Xerox Corp. v. United States, 41 F.3d 647, 657 (Fed. Cir. 1994) ("A foreign country's internal procedures do not determine United States tax credit rules. . . .").

C. The Bx Payments Cannot Be Rebates Under the Facts

The trial court ignored more than just Section 901(i) and Banker's Trust; it also ignored myriad factual breaks in the supposed chain of payments used to treat the Bx Payments as rebates of the Trust's taxes. For example, the parties may have initially calculated the Bx Payments by reference to the U.K. tax credits that Barclays expected to receive, but the Bx Payments were fixed by the parties ex ante in the transaction documents and not linked to Barclays' actual receipt of any U.K. tax benefit. (See JA37.) In fact, the transaction documents obligated Barclays to make the Bx Payments independent of (and in most cases, before) the Trust's payment of U.K. taxes or Barclays' receipt of any credit or loss deduction. (JA15855; JA725.) The trial court further recognized that Barclays was subject to the risk of a successful challenge by the U.K. tax authorities that "would invalidate . . . Barclays' expected U.K. tax benefits under STARS." (JA39). Barclays could not rebate something that it did not have and might never get, and thus the Bx Payments could not represent "in substance" rebates of the U.K. taxes paid by the BB&T.

D. The Bx Payments Are Economic Income

Stripped of the rebate label, the Bx Payments cannot be a "tax effect" and must be included in the pre-tax income of the Trust. As a matter of law, payments to reimburse a party's tax expense represent non-tax, economic income, and the foreign tax credit rules expressly recognize that taxpayers may claim credits under Section 901 for reimbursed foreign tax expense. Similarly, payments between private parties in exchange for tax benefits are not "tax effects"; they are economic income as a matter of law. Because the Bx Payments represent economic income, the Trust Transaction has economic substance, and BB&T must be allowed to claim its foreign tax credits (and transaction cost deductions).

 

1. Payments Reimbursing Tax Costs Are Not Tax Effects

 

Decades of precedents hold that a party whose tax liability is discharged by someone else has economically benefitted and so must include that amount in its income. See Old Colony Trust Co. v. Comm'r, 279 U.S. 716, 728-29 (1929) (payment of tax by third party "is equivalent to receipt by the person taxed"); Diedrich v. Comm'r, 457 U.S. 191, 197 (1982) ("[T]he donor realizes an immediate economic benefit by the donee's assumption of the donor's legal obligation to pay the gift tax."). In this case, as the trial court held, the Bx Payments "reimbursed" BB&T for its U.K. taxes. Under Old Colony Trust and the trial court's holding, BB&T had to include the Bx Payments in its pre-tax income. The trial court's decision to exclude the Bx Payments in determining the pre-tax profitability of the Trust Transaction contradicts existing law.

The Fifth and Eighth Circuits reached the same conclusion in cases similar to this one. See Compaq Computer Corp. v. Comm'r, 277 F.3d 778, 785 (5th Cir. 2001); IES Indus., Inc. v. United States, 253 F.3d 350, 351 (8th Cir. 2001). In both cases, the taxpayer purchased investment securities in a public company, referred to as American Depository Receipts (ADRs), immediately before a dividend and then sold them immediately after the dividend in prearranged transactions. Compaq, 277 F.3d at 779; IES, 253 F.3d at 351. The dividend paid wassubject to a 15-percent foreign tax, so the taxpayers received only $85 for every $100 of dividends. Compaq, 277 F.3d at 780; IES, 253 F.3d at 351. The taxpayers also realized a capital loss of $85 on the sale of the ADRs because the market value of the ADRs declined as a result of the dividend. Compaq, 277 F.3d at 780; IES, 253 F.3d at 352. The taxpayers paid fees and commissions (assume $1.50). The taxpayers reported taxable dividend income equal to the $100 gross dividend and claimed a $15 foreign tax credit for the tax withheld and paid to the foreign government. Compaq, 277 F.3d at 780; IES, 253 F.3d at 352-53.

As here, the cases turned on whether the ADR transactions had a prospect for pre-tax profit, which turned on how to treat the $15 tax payments made by the issuers. The Government argued that the payments should be ignored, resulting in a pre-tax loss for the taxpayer ($85 of dividend revenue, less $85 loss from sale of ADRs, less $1.50 of fees and commissions). The taxpayers argued that the issuer's satisfaction of the taxpayer's tax liability was income, resulting in significant pre-tax profit ($100 of dividend revenue, less $85 loss from sale of ADRs, less $1.50 of fees and commissions). Relying on Old Colony and Diedrich, both appellate courts sided with the taxpayers. See IES, 253 F.3d at 354; Compaq, 277 F.3d at 783-84. Both courts were troubled by the inherent contradiction of the Government's position -- that a payment of the taxpayer's foreign tax liability must be ignored when determining a transaction's pre-tax profit but must be treated as income for U.S. tax purposes. See, e.g., IES, 253 F.3d at 354.

BB&T's position here and the Fifth and Eighth Circuits' holdings are consonant with the foreign tax credit regime. Foreign tax credit regulations have long declared that "[t]ax 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); see Biddle v. Comm'r, 302 U.S. 573, 580-82 (1938); Guardian Indus. Corp. v. United States, 47 F.3d 1368, 1372 (Fed. Cir. 2007) (recognizing "the general and undisputed proposition that the party who pays the [foreign] tax may not be the party that is legally liable for the tax"). Congress itself has recognized that foreign borrowers frequently "promise [U.S.] lenders a certain after-foreign tax interest rate on the loans and agree to assume the lenders' liability for any foreign taxes imposed. . . . In general, under the regulations, foreign taxes paid by foreign borrowers pursuant to such arrangements are creditable in full by the U.S. lenders: the taxes are considered paid by the lenders notwithstanding that the foreign borrowers agree to pay them. . . ." H.R. Rep. No. 99-426, at 349 (1985).6 By design, federal law eliminates any inquiry into the economic burden of a foreign tax. In the foreign tax credit system, "no attempt is made to trace the economic incidence of a creditable tax beyond the technical taxpayer . . . . [I]t would be very difficult for courts to decide in individual cases where the burden of many taxes ultimately falls, and even if they could make this decision, opening the question would add enormously to the uncertainty of the law." Elisabeth A. Owens, The Foreign Tax Credit 387 (1961).

The trial court nevertheless engaged in that prohibited inquiry. Despite extensive briefing on Old Colony, Compaq, IES, and the Government's own rules, (see JA49690-96; JA49731-38), the trial court ignored them all. The court's holding that BB&T's claim of foreign tax credits is improper because Barclays reimbursed BB&T "for one-half of its out-of-pocket U.K. tax costs," (JA55), cannot be reconciled with the law. It should be reversed.

 

2. Private-Party Payments Calculated by Reference to Tax Benefits Are Not Tax Effects

 

The calculation of the Bx Payments by reference to Barclays' expected U.K. tax credit does not convert the payments into a rebate or tax effect. Private parties regularly plan for and share tax benefits when pricing transactions. See, e.g., Staff of J. Comm. on Tax'n, 110th Cong., Description of the Chairman's Amendment in the Nature of a Substitute of H.R. 3996, the "Temporary Tax Relief Act of 2007," JCX-106-07, 116 n.205 (2007), available at https://www.jct.gov/publications.html?func=showdown&id=1358 (recognizing that unrelated parties adjust sales prices to account for tax benefits obtained by purchaser); Tech. Adv. Mem. 98-21-003 (Feb. 9, 1998) ("[N]othing in the regulations denies foreign tax credits for taxpayers that consider the economic impact of foreign taxes and the foreign tax credit when negotiating transactions"); Victor Fleischer & Nancy Staudt, The Supercharged IPO, 67 Vand. L. Rev. 307, 310 n.4 (2014) ("That the sharing of tax benefits and liabilities occurs both implicitly and explicitly is widely understood and extensively studied."). The Government's own contracts often expressly agree to split tax benefits accruing to private taxpayers. See, e.g., Centex Corp. v. United States, 49 Fed. Cl. 691, 708 (2001) (Federal Savings and Loan Insurance Corporation and taxpayer "agreed to a fifty-fifty split of the benefits derived from the covered asset loss deduction").

Contractual payments between private parties are not "taxes" or "tax effects" just because they are calculated by reference to expected tax benefits. For example, in Doyon Ltd. v. United States, 37 Fed. Cl. 10 (1996), rev'd on other grounds, 214 F.3d 1309 (Fed. Cir. 2000), the court refused to treat a private party's side payment for expected tax benefits from a transaction as a tax benefit in substance. Even though the "dominant factor" in calculating the side payments was the anticipated tax savings, and even though the payments were "quid pro quo consideration" for the tax savings, it did "not change the fact that Doyon received its consideration from private parties, pursuant to a private contractual agreement." Id. at 23. The side payments in Doyon and the Bx Payments in this case are indistinguishable: both are private-party payments calculated by reference to expected tax savings. It is not the "ultimate source" of the Bx Payments that determines their nature; it is "the immediate, actual and sole source[ ]" of the Bx Payments, which was Barclays. Id. (emphasis in original).7

A further reason why the Bx Payments are income and not "tax effects" is that, in cases where payments between private parties sourced from U.S. tax benefits represented expenses to taxpayers, courts include the payments in their pre-tax profit analysis without inquiring whether the payments were "tax effects." For example, in Wells Fargo & Co. v. United States, 91 Fed. Cl. 35, 82 (2010) (Wheeler, J.), aff'd on other grounds, 641 F.3d 1319 (Fed. Cir. 2011), the court treated an "inducement fee for transferring the tax benefits" paid by the U.S. taxpayer as an expense for purposes of calculating pre-tax profit under the economic substance doctrine (ultimately creating a pre-tax loss), id. at 82, even though the inducement fee was necessarily sourced from tax benefits that represented the sole source of profit in the transactions, id. at 75. The Government has also advocated for treating private-party payments sourced from taxes as a pre-tax expense in other cases when demonstrating an expected pre-tax loss from a transaction. See, e.g., United States Opening Post-Trial Br. at 15, 19, 116, Consol. Edison Co. of N.Y., Inc. v. United States, 90 Fed. Cl. 228 (2009) (No. 06-305T), ECF No. 99 (including accommodation fee "driven by [Con Ed]'s tax benefits" in pre-tax profit calculations); (JA49743-48). There is no principled reason why private-party payments sourced from tax should be treated as pre-tax expenses to the paying taxpayer but ignored as "tax effects" by the recipient taxpayer.

 

3. Other Case Law Is Inapt

 

Without addressing the authorities described above, the trial court cited and relied upon the Tax Court's decision involving a similar STARS transaction. (JA55 (citing BNY I).) In that case, the Tax Court disregarded payments equivalent to the Bx Payments, reasoning that the use of "tax savings" to reduce the cost of the financing in that case was not a valid business purpose, citing Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254 (1999), aff'd, 254 F.3d 1313 (11th Cir. 2001),and American Electric Power Co. v. United States, 326 F.3d 737 (6th Cir. 2003). BNY I, 140 T.C. at 32. Those cases do not support treating the Bx Payments as "tax effects." They stand for the (irrelevant) proposition that the anticipated use of the tax savings from a sham transaction does not represent a valid, non-tax purpose for generating tax benefits in the first instance. See Winn-Dixie, 113 T.C. at 287-88; Am. Elec. Power, 326 F.3d at 744. The Winn-Dixie and American Electric Power courts did not analyze the question at hand -- whether a payment between unrelated private parties could be treated as a tax effect and ignored when calculating pre-tax profit.

 

III. THE TRIAL COURT COMMITTED LEGAL ERROR BY DISREGARDING

 

THE U.K. TAX LAWFULLY IMPOSED ON THE TRUST'S INCOME

 

 

The trial court also erred by questioning the United Kingdom's imposition of tax on the Trust. The court reasoned (i) that the United Kingdom never should have taxed the Trust's income because the distributions to and from the Trust were circular and the Trust's U.K. activity was insubstantial, and (ii) that the U.K. tax should not be recognized because the Trust Transaction is insubstantial and meaningless for U.S. tax purposes. (See JA3 ("no economic activity has occurred abroad to justify the assessment of a U.K. tax"); JA59 ("BB&T artificially caused a U.K. tax on U.S.-sourced revenue."); JA59-60 ("There was no substantive economic activity occurring in the U.K. to warrant a U.K. tax.").) These conclusions appear to be based in part on the supposedly circular flows of cash into and out of the Trust, which the court described as "meaningless monthly transfers, none of which had any economic substance." (JA54.) Whatever the trial court meant, it committed several legal errors and failed to account for the governing foreign tax credit regime and the Treaty.8

First, the act of state doctrine barred the trial court from reconsidering the United Kingdom's imposition and collection of income tax from the Trust. The act of state doctrine bars U.S. courts from questioning the official actions of a foreign sovereign, reflecting "the strong sense of the Judicial Branch that its engagement in the task of passing on the validity of foreign acts of state may hinder the conduct of foreign affairs." Riggs Nat'l Corp. v. Comm'r, 163 F.3d 1363, 1367 (D.C. Cir. 1999) (internal quotations and citations omitted); see also Voda v. Cordis Corp., 476 F.3d 887 (Fed. Cir. 2007) (stating that the act of state doctrine "'requires that, in the process of deciding, the acts of foreign sovereigns taken within their own jurisdictions shall be deemed valid." (internal quotation omitted)). The trial court should not have sat in judgment over the U.K. Exchequer's imposition and collection of U.K. income tax from the Trust.

Second, the trial court failed to recognize that different sovereigns may have different and conflicting legal standards for determining fundamental tax issues -- such as whether an entity is resident, a transaction is respected, or income is recognized. See, e.g., Pepsico P.R., Inc. v. Comm'r, 104 T.C.M. (CCH) 322, 344 n.44 (2012) (recognizing that in international financing transactions, "two separate tax regimes both endeavor to apply their respective tax laws to transactions considering, primarily, the objective terms of the governing instruments."); I.R.S. Field Serv. Adv. 2001-39-008 (May 15, 2001) ("A U.S. taxpayer's proper treatment of items for U.S. income tax purposes may not necessarily conform to their proper treatment under foreign law."). In this case, the Trust was a flow-through entity (either a partnership or disregarded into BB&T) whose income was not separately subject to U.S. tax, and the flows to and from the Trust gave rise to no separate U.S. tax consequences relevant to the STARS transaction. See supra pp.13-14. By contrast, the Trust was treated as a separate entity for U.K. tax purposes, subject to U.K. income tax on its worldwide income, and the flows to and from the Trust triggered independent U.K. tax consequences. Supra pp. 10-13. There is no dispute that the United Kingdom taxed the Trust's income, made the Trust liable to pay those taxes, and threatened the Trust with penalties if it did not pay -- all because the Trust was a resident of the United Kingdom pursuant to its income tax laws. (See JA705.) The fact that the Trust conducted little activity in the United Kingdom is not relevant to its assertion of taxing jurisdiction -- the United Kingdom, like the United States, has long imposed tax on entities that are U.K. residents under its laws regardless of where the entity conducts activity. (See JA705; JA900); I.R.S. Priv. Ltr. Rul. 5812056040A (Dec. 5, 1958) (reviewing history of U.S. residence rules and acknowledged disregard of situs of entity's activities under those rules).

Third, the trial court's reconsideration of the imposition of U.K. tax on the Trust conflicts with the express allocation of tax jurisdiction in the Treaty. Sovereigns enter into tax treaties to resolve conflicts among their standards for determining residence, taxable income, and the like. The Treaty expressly grants the United Kingdom the primary right to tax entities such as the Trust that are disregarded or are flow-through entities for U.S. tax purposes but are respected as separate taxable entities for U.K. tax purposes ("fiscally transparent entities"). See Technical Explanation art. 24 at 95 ("Under paragraph 4 or 8 of Article 1, a Contracting State may tax an entity as a resident even though the other Contracting State views the entity as fiscally transparent (e.g., as a partnership) and taxes its own residents on the same income. . . . The effect is to give primary taxing rights to the State in which the entity is a resident, and ensure that double tax is relieved by having the other State give a foreign tax credit for the taxes paid by the entity." (emphasis added)).9 The imposition of U.K. tax is not a benefit that BB&T claimed; it is a right granted to the United Kingdom that no U.S. judicial doctrine can deny.

Fourth, long-standing Government interpretations and applications of Section 901 directly contradict the trial court's suggestion that the Trust's quantum and kind of activity determine whether its payment of U.K. taxes should be respected. Recognizing the disparate standards for determining taxable income across borders, the Government has declared that "[w]e think that Code § 901 allows a credit for foreign income taxes paid, without regard to whether the foreign government's definition of taxable income coincides with our own and we do not attempt to recompute the foreign tax under foreign law," I.R.S. Gen. Couns. Mem. 35,220 (Jan. 30, 1973) (emphasis added),and that "we do not intend to question the tax accounting standards of the foreign country in determining the amount of foreign tax to be used in computing the foreign tax credit," I.R.S. Priv. Ltr. Rul. 7609101040A (Sept. 10, 1976). Applying this principle, the Government has consistently permitted credits for foreign taxes imposed on (i) circular flows of funds between a subsidiary and parent that were disregarded for U.S. tax purposes but respected and taxable for foreign tax purposes;10 (ii) income from transactions between related parties that the United States refuses to respect but that the foreign country respects;11 and (iii) transactions among entities disregarded for U.S. tax purposes but respected as separate entities for foreign tax purposes.12 Thus, while the trial court appeared to disregard BB&T's U.K. tax payments because the Trust performed insufficient U.K. activity and received circular and "meaningless" flows, the Government has consistently recognized and granted credits under Section 901 in analogous circumstances.

The granting of credits in these cases is rooted in the Government's formal adoption of the principle (dating back to 1954) that Section 901 permits credits for foreign income taxes imposed on payments or other items not recognized as foreign-source income or as income at all for U.S. tax purposes. See Rev. Rul. 54-15, 1954-1 C.B. 129. "After losing a number of court cases, the [Government] long ago conceded that the amount of creditable foreign tax is the amount paid to the foreign government (assuming the tax examined in its entirety is a qualified income tax) regardless of whether the foreign government taxes some items that under United States law would not be income." I.R.S. Gen. Couns. Mem. 38,467 (Aug. 11, 1980); see Schering Corp. v. Comm'r, 69 T.C. 579, 592 (1978), acq. 1981-2 C.B. 1. The Government adopted foreign tax credit regulations reflecting this principle in 1992, see Treas. Reg. § 1.904-6(a)(1)(iv), and Congress codified this regulation in 2004. See Section 904(d)(2)(H); H.R. Rep. No. 108-755, at 381-85 (2004) (Conf. Rep.).13

The trial court's analysis of the Trust's activity also contradicted analogous applications of Section 901 by this Court and other appellate courts. For example, in Guardian Industries, 477 F.3d at 1369-70, this Court permitted a U.S. holding company that conducted no activity in Luxembourg to claim credits for Luxembourg income taxes. Pursuant to Luxembourg law, taxes were imposed on the U.S. holding company's Luxembourg subsidiary, which the company disregarded for U.S. tax purposes. Id. at 1369. The subsidiary conducted no activity and earned no income in Luxembourg but was treated as the payor of Luxembourg taxes imposed on the income of separate operating subsidiaries solely because it held their stock. Id. at 1373-75. Similarly, the Fifth and Eighth Circuits in Compaq and IES upheld foreign tax credits against economic substance challenges where the taxpayers had no foreign activity but simply bought and sold securities in a matter of minutes or hours in prearranged transactions designed to minimize risk.14 Rejecting the trial court's view that the foreign tax credit served to "facilitate international business transactions" and should be unavailable where "[n]o bona fide business is implicated," Compaq Computer Corp v. Comm'r, 113 T.C. 214, 225 (1999), rev'd, 277 F.3d 778 (5th Cir. 2001), the Fifth Circuit held that foreign tax credits simply prevent double taxation and should be available wherever a taxpayer is taxed twice. Compaq, 277 F.3d at 785.

Finally, sovereign states cannot be disregarded under judicial substance doctrines, nor can their receipt of tax be cast as "meaningless from an economic perspective." (JA 54.) An economic analysis of a sovereign's tax take from a transaction proves nothing: any transaction involving a payment from one party to another leaves the sovereign's treasury economically flat because one party recognizes income and another party claims a deduction in the same amount. No case law supports the disregard of payments of validly imposed and unrebated taxes to a sovereign state; instead, case law respects such payments even if the underlying transactions or entities paying the tax are disregarded for U.S. tax purposes. See, e.g., Guardian Indus., 477 F.3d at 1369 (when a U.S. parent owns a disregarded subsidiary, "[t]he U.S. Parent then reports the income of both entities on its U.S. tax return and can claim a foreign tax credit for foreign taxes paid by the subsidiary"); Lang v. Comm'r, 100 T.C.M. (CCH) 603, 604 (2010) (applying substance doctrines to recast transaction but refusing to disregard payment of real estate taxes); Uniroyal Inc. v. Comm'r, 65 T.C.M. (CCH) 2690, 2697 (1993) (applying substance doctrines to analyze a transaction but refusing to disregard "real world consequences" of taxes resulting from the transaction). While BB&T already disregarded for U.S. tax purposes the supposedly circular cash flows relied upon by the trial court, BB&T's U.K. tax payments were distinct from those supposed circles and were actual economic outflows with real world consequences.

 

IV. NON-TAX BUSINESS PURPOSES MOTIVATED

 

THE TRUST TRANSACTION

 

 

Because the Bx Payments represent pre-tax income, the Trust Transaction was motivated by non-tax business purposes. Viewed in isolation, the Trust Transaction permitted BB&T to earn Bx Payments, an economic benefit of approximately $50 million per year, (JA47303-04), and generate approximately $16 million of state tax savings per year, (JA11748). Both are valid, non-tax business purposes. Earning a profit is a quintessential business purpose, universally accepted by the courts. See, e.g., Jade Trading, LLC v. United States, 598 F.3d 1372, 1377 (Fed. Cir. 2010); United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014, 1019 (11th Cir. 2001); Compaq, 277 F.3d at 786. Similarly, transferring assets to reduce the amount of state tax owed is a valid business purpose. See, e.g., Rev. Rul. 79-289, 1979-2 C.B. 145.

It is undisputed that BB&T established the Trust so that Barclays could create U.K. tax benefits, (JA38-39), and that represents a legitimate business purpose as well. Reducing foreign taxes is an acceptable business purpose. See I.R.S. Field Serv. Adv., 1998 FSA Lexis 153, at *31 (Aug. 21, 1998) ("A purpose to reduce foreign taxes is not the type of tax-avoidance motive that will trigger application of the economic sham doctrine."); I.R.S. Tech. Adv. Mem. 98-21-003 (Feb. 9, 1998) ("[N]othing in the [foreign tax credit] regulations denies foreign tax credits for taxpayers that consider the economic impact of foreign taxes and the foreign tax credit when negotiating transactions."); see also I.R.S. Field Serv. Adv. 003803 (June 3, 1996) (updated on Jan. 31,2006) ("The transfer of cash from UK Sub to US Parent, although transitory, had independent economic significance and a discrete business purpose in that it was necessary in order to achieve the desired U.K. tax benefits."). Likewise, accommodating a counterparty's tax position is a legitimate business purpose. See N. Ind. Pub. Serv. Co. v. Comm'r, 105 T.C. 341, 347-48 (1995), aff'd, 115 F.3d 506 (7th Cir.1997) (holding that the taxpayer had a legitimate business purpose to insert a newly formed foreign corporation in a cross-border financing transaction solely to comply with foreign lender demands to eliminate U.S. tax on interest paid to the lenders). BB&T's accommodation of Barclays' tax objectives in this case fits that bill.

The trial court's view that BB&T "self-inflicted" its income to U.K. tax and otherwise "voluntarily" paid U.K. taxes, (JA47; JA54; JA56), is not a valid basis to deny foreign tax credits. Regulations interpreting Section 901 determine when and to what extent a foreign tax is non-compulsory or "voluntary." See Treas. Reg. § 1.901-2(e)(5)(i). The regulations do not question a taxpayer's reasons for earning income subject to foreign tax; a taxpayer can "self-inflict" its income to foreign taxation if it so chooses.15 Instead, the regulations require the taxpayer to conduct substantive legal, factual, and cost-benefit analyses to determine the proper amount of its foreign tax liability and to take reasonable actions under foreign law to reduce its foreign tax burden. Treas. Reg. § 1.901-2(e)(5)(i). The Government agreed that BB&T satisfied the regulations and that its tax payments were no greater than the United Kingdom required. (JA43553.) The trial court had no warrant to ask whether BB&T's activity was "self-inflicted" and could not reasonably conclude that BB&T's U.K. tax payments were "voluntary."

 

V. BB&T MUST BE ALLOWED TO CLAIM AT LEAST

 

FORTY-NINE PERCENT OF THE FOREIGN TAX CREDITS

 

UNDER THE TRIAL COURT'S FLAWED REASONING

 

 

While the trial court's conclusion that BB&T's foreign taxes were rebated was legally erroneous, its reasoning does not justify the denial of all of BB&T's foreign tax credits. Even accepting the court's flawed logic, the Bx Payments rebated only $51 of every $100 BB&T paid in U.K. taxes. Accordingly, $49 of BB&T's U.K. taxes were not rebated -- they were retained by the U.K. Exchequer. BB&T must be allowed foreign tax credits to that extent because economically substantive portions of a transaction must be given effect under the tax law even when another portion of the transaction lacks substance. See Coltec, 454 F.3d at 1360 (disregarding transfer of contingent liabilities but remanding to determine propriety of deduction claimed with respect to contemporaneous transfer of other property); see also ACM P'ship v. Comm'r, 157 F.3d 231, 262 (3d Cir. 1998) (allowing deduction that"accurately reflects the economic reality of [the taxpayer's] transactions" where other deductions were disallowed under economic substance doctrine).

The operation of this judicial substance doctrine principle is illustrated in Stewart v. Commissioner, 58 T.C.M. (CCH) 152 (1989). There, the law gave taxpayers a residential energy tax credit equal to 40 percent of the purchase price of solar heating panels. Id. at 156. To increase purchasers' credits, the sellers in Stewart artificially inflated the price of the solar panels and simultaneously offered "support payments" that effectively reduced the purchasers' out-of-pocket expenses to the arm's length price. Id. Although the "support payments" were rebates of the purchase price designed "to manipulate . . . the Federal income tax laws," the taxpayer was allowed to claim a portion of the credit -- 40 percent of the post-rebate purchase price. Id. at 157.

Disallowing all of BB&T's foreign tax credits, as the trial court did, is contrary to the Code. Foreign tax credits can be disallowed only to the extent that the foreign tax results in an indirect rebate or subsidy. See Section 901(i) ("Any income . . . tax shall not be treated as a tax for purposes of this title to the extent -- (1) the amount of such tax is used . . . to provide a subsidy . . .") (emphasis added); Treas. Reg. § 1.901-2(e)(2)(i) (same). Allowing the Government to collect more tax by using judicial substance doctrines to characterize the Bx Payments as "effective rebates" than it could have collected if the relevant statutes actually applied is legal error; judicial substance doctrines are tools of statutory construction that fulfill Congress's purposes, not defeat them.

 

VI. BB&T IS ENTITLED TO CLAIM INTEREST EXPENSE DEDUCTIONS

 

 

BB&T claimed deductions for interest it paid in connection with the $1.5 billion Loan. See Section 163(a). The trial court disallowed those deductions, holding that the Loan lacked economic substance. (JA56.) That was legal error.16

The economic substance doctrine identifies transactions that "lack . . . economic reality" because they "do not vary control or change the flow of economic benefits." Coltec, 454 F.3d at 1355 (emphasis and quotations omitted). Far from lacking economic reality, the Loan was a "$1.5 billion loan from Barclays to BB&T," (JA2), that "BB&T surely would use . . . to generate revenue" in its banking business, (JA57). A loan transaction has economic substance if it "could . . . appreciably affect the taxpayer's beneficial interest" apart from tax benefits. Coors v. United States, 572 F.2d 826, 860 (Ct. Cl. 1978); Rothschild v. United States, 407 F.2d 404, 417 (Ct. Cl. 1969). Consistent with this rule,interest deductions have been disallowed under the economic substance doctrine only where the sole purpose of a borrowing was to generate interest deductions. See Goldstein v. Comm'r, 364 F.2d 734, 741 (2d Cir. 1966); Lee v. Comm'r, 155 F.3d 584, 586 (2d Cir. 1998) (reaffirming "the undoubted proposition that interest on loans incurred to support an economically substantive investment is not disqualified as a deduction merely because the borrower is also motivated by favorable tax consequences."); (JA50151-53). Here, the Loan was "surely . . . use[d] . . . to generate revenue," (JA57), and thus not solely to generate deductions. Under the law of this Circuit, the Loan must be respected.

Notably, the Tax Court held that Bank of New York could take deductions for interest expense in connection with the loan in its STARS transaction, which the Government concedes is "substantively identical" to BB&T's STARS transaction. See BNY II, T.C. Memo 2013-225, at *4; (JA49039). There, the loan proceeds were "available for petitioner to use in its banking business" and therefore "served a purpose beyond the creation of tax benefits." BNY II, T.C. Memo 2013-225, at *4. So too here.

Contrary to the above authority, trial court offered two bases for holding that the Loan lacked economic substance. First, the court held that the Loan did not provide a potential for pre-tax profit because it was relatively expensive compared to other loans. Second, the court held that the Loan served solely to "camouflage" the rebate of a portion of BB&T's U.K. taxes. (See JA56.) Both bases are wrong as a matter of law. See BNY II, T.C. Memo 2013-225 at *4 (rejecting the same arguments).

First, the trial court's consideration of interest rates on other loans is legal error. In assessing the economic substance of a loan, this Court has never compared borrowing rates available to a taxpayer. See Coors, 572 F.2d at 838-39 (allowing interest deductions without analysis of interest expense of alternative loans); Rothschild, 404 F.2d at 417 (listing a number of reasons for denying interest deductions but not analyzing cost of alternative loans). Instead of linking the economic substance of a loan with the loan's interest rate, the predecessor to this Court linked it with the taxpayer's intended use of the borrowed funds. Coors, 572 F.2d at 855 ("[T]he use of borrowed funds . . . has a significance far greater than the creation of tax deductions. . . ."); Rothschild, 407 F.2d at 405 ("The issue is: whether interest paid for borrowed funds to be invested in a transaction which on its face yields no net pre-tax earnings. . . ." (emphasis added)). The trial court here ignored that authoritative view, holding that BB&T's "use [of] the Loan proceeds to generate revenue . . . is irrelevant for purposes of the economic substance analysis." (JA57.) But the decisions the trial court cited in support of its view stand for the different (and unsurprising) proposition that taxpayers cannot rely upon the very tax savings at issue to demonstrate the economic substance of a transaction. See Winn-Dixie, 113 T.C. at 287; Am. Elec. Power, 326 F.3d at 744; Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219, 264-66(D.N.J. 2009) (relying on Winn-Dixie and American Electric Power), aff'd sub nom. Merck & Co. v. United States, 652 F.3d 475 (3d Cir. 2011).

Second, the trial court's contention that "[t]he Loan simply was a method by which to camouflage" the Bx Payments (and therefore somehow lacked substance), (JA56), is objectively false. Instead, the record plainly demonstrates that BB&T -- like the other U.S. banks -- engaged in STARS for the purpose of obtaining financing. (JA281; JA481; JA50052-53 (citing JA2385).) Moreover, the loan was not tax "camouflage" because no disguise was needed -- before BB&T was approached by Barclays, KPMG had reviewed a version of STARS with no loan and determined that it satisfied U.S. tax requirements. (JA2400.) Moreover, even if BB&T did view the Loan as "camouflage," the Loan also had a non-tax economic benefit -- the potential to "appreciably affect [BB&T]'s beneficial interest" by BB&T's unrestricted use of the borrowed funds in its banking business. See Coors, 572 F.2d at 860. Accordingly, the Loan cannot be disregarded.

 

VII. BB&T Is Not Liable for Accuracy-Related Penalties

 

 

The District Court in Massachusetts recently determined that the STARS trust before it, which was virtually identical to the STARS trust before this Court, (see JA12), had economic substance as a matter of law. Santander, 2013 WL 5651414, at *6. The District Court held that the taxpayer's "payment of the U.K. tax and claiming of the U.S. foreign tax credit did not produce an improper tax benefit." Id. at *3, *7.

Even assuming that reasonable minds can differ on the question, the fact that the District Court agreed with BB&T's position objectively proves BB&T's reasonableness and forecloses imposing penalties in this case. "Simply put, the objective reasonableness of a tax position becomes virtually unassailable when the taxpayer actually prevails at trial before a district judge who was not compromised by conflict, substance abuse, or senility." TIFD III-E Inc. v. United States, Nos. 01-cv-1839, 01-cv-1840, 2014 WL 1274052, at *7 (D. Conn. Mar. 28, 2014).

A taxpayer can avoid penalties by establishing reasonable cause. Section 6664(c). Generally, the most important factor in determining reasonable cause is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Treas. Reg. § 1.6664-4(b); see United States v. Boyle, 469 U.S. 241, 250-51 (1985) (a taxpayer need not challenge its advisor's conclusions, seek a second opinion, or even check the advice itself to have reasonable cause). BB&T had reasonable cause because it reasonably relied upon its advisors. BB&T received opinions from two firms (KPMG and Sidley), (JA19720-853; JA21989-2181), and received additional advice from its financial auditor (PwC), (JA25783-784). At least fifteen tax professionals, four of whom either before or after reviewing STARS held high-ranking tax administrative positions in the U.S. government, weighed in. (JA49478-79; JA49488-90; JA48730-33.) Each agreed that BB&T's tax treatment was reasonable, and that if challenged, BB&T would have, at a minimum, a two-in-three chance of prevailing in court. (See JA25784; JA9598; JA1171.) The trial court's rationale for rejecting BB&T's reasonable cause defense cannot withstand scrutiny. See Pullman-Standard v. Swint, 456 U.S. 273, 287 (1982) (findings that rest on an erroneous view of the law may be set aside); see also Stobie Creek Invs., 608 F.3d at 1381 (reasonable cause determinations reviewed for clear error).

A. BB&T's Reliance on Sidley Established Reasonable Cause

Sidley was engaged on April 26, 2002, over three months before BB&T entered into the STARS transaction. (JA10443; JA905.) Sidley provided a U.S tax and a U.K. tax opinion. (JA21989-2181; JA22184-92.) In the fall of 2003, after Sidley expelled the attorney who drafted BB&T's U.S. STARS opinion for his involvement in unrelated tax shelters, and after a review of the BB&T STARS opinion by other tax partners at the law firm, Sidley assured BB&T that it continued to stand behind its tax advice. (JA49519-21.)

The trial court held that Sidley was a promoter of STARS and as a result BB&T was not entitled to rely on Sidley's advice. (JA61-62.) That was legal error. By definition, promoters (i) develop a tax strategy, (ii) recommend it to taxpayers, and (iii) "profit considerably" because they are compensated based on a percentage of anticipated tax savings. See Stobie Creek, 608 F.3d at 1382; see also Alpha I, L.P. v. United States, 93 Fed. Cl. 280, 315-16 (2010). Sidley had none of those traits.

First, Sidley had no role in developing STARS. Nine months before Sidley evaluated BB&T's STARS transaction, Barclays completed the first STARS transaction with First Union. (JA16; JA24.) Mayer Brown, not Sidley, was the U.S. tax counsel for that transaction. (JA455; JA305.)

Second, Sidley did not recommend or present STARS to BB&T;rather, Barclays did. (JA17.) When BB&T first obtained tax advice, it went to KPMG in January 2002. Id. BB&T did not speak to Sidley until months later -- after speaking with multiple other firms and after exchanging initial draft documentation with Barclays. (JA49484-86.)

Third, Sidley was compensated with a flat fee that was not calculated in reference to any portion of alleged "tax savings." (JA10430; JA49486-87.)

The trial court's holding was also lacks foundation in the record. First, in finding that Sidley worked with Barclays to create STARS, the court conflated two unrelated statements from one Barclays witness, Mr. Sultan. (JA7.) Mr. Sultan testified that he was involved in creating STARS, (JA46737), and that he had worked with a Sidley attorney, R.J. Ruble, on different matters in the 1990s, (JA46799). The court mischaracterized this testimony as an admission that Mr. Sultan had worked with R.J. Ruble to create STARS. Second, in finding that Sidley induced BB&T to engage in STARS, the court found that BB&T hired Sidley after receiving a redacted STARS tax opinion. (JA63.) The contemporaneous evidence, however, shows that BB&T retained Sidley before it received a redacted tax opinion. (JA10443; JA49486-88.)

B. BB&T's Reliance on PwC Established Reasonable Cause

Months before BB&T executed the STARS transaction, PwC conducted an in-depth, hazards-of-litigation analysis, (JA1170-71), and concluded that BB&T had a two-in-three chance of prevailing. (JA25784; JA9598; JA1171.) PwC tax practitioners, including international tax experts from PwC's Washington National Tax Office worked with BB&T and discussed potential tax issues on multiple occasions. (JA598-601; JA8984-86; JA9448; JA9598; JA49488-90; JA49497-98.) PwC also interacted directly with KPMG and discussed tax issues related to the proposed STARS structure, culminating in an April 19, 2002, conference call among BB&T, KPMG, and PwC, to allow BB&T to evaluate both advisors' tax analysis and conclusions. (JA9598; JA49505-06.) PwC reviewed and commented on KPMG and Sidley's tax opinion drafts at BB&T's request to ensure that the KPMG and Sidley opinions reached reasonable conclusions. (See JA13187; JA16510-23; JA16818; JA17188; JA17720; JA20213; JA21451; JA49498-99.) Finally, PwC reviewed the transaction again in 2004 at BB&T's request and confirmed its original conclusions. (JA25773; JA25783-84.)17

The trial court gave several reasons for rejecting BB&T's reliance on PwC's advice. (JA63.) None hold up.

First, it is legally irrelevant that PwC did not provide BB&T a formal written opinion regarding STARS and that BB&T did not report PwC's tax advice to the IRS. Tax advice can include "any communication . . . setting forth the analysis or conclusion" of a tax advisor. Treas. Reg. § 1.6664-4(c)(2) (emphasis added). It does not have to "be in any particular form," such as that of a formal opinion, and there is no requirement that advice be disclosed to the IRS in any tax filing. Id. PwC's 2004 memorandum reflects the depth of PwC's analysis, the expertise it brought to bear in its review, and its level of confidence. (JA25781-86.) Relative to PwC's analysis, far less significant, unreported involvement by an accounting firm has been found to be relevant to reasonable cause. See Am. Boat Co. v. United States, 583 F.3d 471, 485 (7th Cir. 2009) (noting that enlisting two independent accounting firms to prepare tax documents, as opposed to providing tax advice with respect to specific transactions, was relevant to reasonable cause).

Second, KPMG's and Sidley's "unreasonable and unsupported representations" did not impact PwC's advice. PwC reviewed the representations and transaction facts independently and reached its own conclusions. (See, e.g., JA17720; JA19862; JA20213; JA21451; JA621; JA1180-81.) Financial accounting standards require independent conclusions, and it is common practice for financial auditors to review any tax opinions obtained by the client. (JA602-03; JA607; JA609; JA25781-86); see also AU Section 9326 -- Auditing Interpretations of Section 326, at .22, available at http://pcaobus.org/Standards/Auditing/Pages/AU9326_22.aspx.

Third, the trial court committed legal error in measuring PwC's advice by the wrong yardstick. A taxpayer can reasonably rely on advice even when its advisor does not conclude that the tax treatment "should" be affirmed. See Treas. Reg. § 1.6664-4(f)(2)(i)(A), (B). A "should" level opinion means the advisor has 70 percent confidence that the tax treatment will be sustained. (JA605.) PwC ultimately had 60-70% level of confidence -- "modestly short of a should" or "strong more likely than not." (JA1177-178; JA25784.) This confidence level is more than sufficient to meet reasonable cause standards. See Treas. Reg. § 1.6664-4(f)(2)(i)(A), (B).

Finally, the trial court's belief that PwC failed to recognize"glaring weaknesses" in the STARS transaction, (JA63), simply reflects the court's erroneous conclusion that the transaction lacked economic substance. PwC analyzed all the same material issues as the trial court and reached a different conclusion. (See JA613 (discussing JA8837); JA1174; JA1180-81.) Most importantly, PwC concluded that STARS had economic substance and a valid business purpose. (JA1180-81.) In performing its hazards of litigation analysis, PwC compared STARS to two recently decided foreign tax credit cases addressing the economic substance question, Compaq and IES, and determined that BB&T's business purpose for engaging in STARS was far stronger than the taxpayers' business purposes in those cases. (JA1181.)

In sum, PwC's advice cannot be deemed unreasonable because PwC disagreed with the trial court. Fifteen tax advisors disagreed with the trial court, as did the Santander court. And the IRS did not assert penalties against Bank of New York, even though Sidley also authored a tax opinion for Bank of New York. (JA49048.)

 

CONCLUSION

 

 

BB&T respectfully asks the Court to reverse the judgment of the trial court and hold that BB&T is entitled to the foreign tax credits, interest deductions, and transaction costs claimed in connection with STARS.
Respectfully submitted,

 

 

Rajiv Madan

 

Christopher Bowers

 

Royce Tidwell

 

Bingham Mccutchen LLP

 

2020 K Street, N.W.

 

Washington, D.C. 20006

 

FOOTNOTES

 

 

1 A former IRS Associate Chief Counsel (International) explained in detail the conflicts between the Government's arguments in the STARS litigation and the various provisions in the foreign tax credit regime. See Kevin Dolan, The Foreign Tax Credit Diaries -- Litigation Run Amok, 71 Tax Notes Int'l 831 (Aug. 26, 2013).

2 In 2005, BB&T made an election on a Form 8832 that resulted in the Trust being disregarded for U.S. tax purposes. (JA39131-35); (see JA47635); Treas. Reg. § 301.7701-3 (providing taxpayers the option of having wholly-owned subsidiaries be either taxed as separate corporations or treated as "disregarded" with all of their activities treated as having been conducted by their owner). Prior to that election, the Trust was treated as a partnership. (JA29.)

3 The court purported to consider the integrated STARS transaction but relied on the same conclusions as in its bifurcated analysis. (JA58-60.)

4 As the Government's expert witness explained, the "real benefit" of STARS was the trading loss deduction. (JA855.)

5 Notwithstanding the above, the trial court relied on the Government's expert economists to hold that the Bx Payments were "economic" rebates of the Trust's taxes. (JA54-55.) Reliance on the Government's economic analysis to establish a rebate is incompatible with the Government's view that Section 901(i) bars taxpayers from presenting economic analyses to establish that they did not benefit from a rebate. See Treas. Reg. § 1.901-2(e)(3)(ii) ("The fact that the U.S. taxpayer may derive no demonstrable benefit from the subsidy is irrelevant in determining whether a subsidy exists."); T.D. 8372, 1991-2 C.B. 338, 339 ("A comment was received which stated that a taxpayer should be allowed the opportunity to avoid subsidy treatment by establishing that it did not, on the basis of all the facts and circumstances, receive a benefit from the subsidy. This comment is inconsistent with the express language of section 901(i), and the Service, consequently, has rejected it."); Cont'l Ill. Corp. v. Comm'r, 998 F.2d 513, 520 (7th Cir. 1993) ("The IRS can hardly be faulted for having chosen a bright-line approach in preference to interminable investigation of the mysteries of public finance, much as the latter approach might appeal to the legal, accounting, and economic-consulting communities.").

6 The Section 901 regulations have included an example since 1983 in which a U.S. person constructs a naval base for a foreign government and the foreign government agrees to assume any tax liability of the U.S. person in such foreign country as a result of constructing the naval base. Treas. Reg. § 1.901-2(f)(2)(ii), Example 3. This example concludes that, for purposes of Section 901, the amount of the tax liability assumed by the foreign government is considered paid by the U.S. taxpayer for purposes of the foreign tax credit rules. See also id., Example 1 (net loan example); Treas. Reg. § 1.901-2A(e)(8), Example 3 (contract with foreign government).

7 The Government has reached similar conclusions in administrative guidance. See, e.g., I.R.S. Priv. Ltr. Rul. 87-42-010 (July 10, 1987); I.R.S. Priv. Ltr. Rul. 2009-51-024 (Sept. 1, 2009) ("[A] payment for the purchase of a transferable tax credit is not a payment of tax.").

8 The trial court also disregarded the uncontroverted fact that BB&T's contribution of assets to the Trust significantly altered the legal and economic rights of BB&T's and unrelated parties (i.e., the FDIC and FHLB) with respect to those assets. (See JA49633-37.)

9See 2001 Treaty art. 4.1 (Trust was resident of United Kingdom for Treaty purposes); id. at art. 1.4 (clarifying that U.K. may tax its residents); Exchange of Notes to arts. 1(8) and 24 of the Treaty (July 24, 2001) (assigning jurisdiction to entities that may be treated as residents of both countries under each country's tax laws); Technical Explanation art. 4 at 15 ("The determination of residence for treaty purposes looks first to a person's liability to tax as a resident under the respective taxation laws of the Contracting States. . . . The term 'resident of a Contracting State'. . . incorporates the definitions of residence in U.S. and U.K. law by referring to a resident as a person who, under the laws of a Contracting State, is subject to tax there by reason of his domicile, residence, citizenship, place of management, place of incorporation or any other similar criterion.").

10See, e.g., I.R.S. Tech. Adv. Mem. 78-40-001 (Sept. 15, 1977)(concluding German withholding taxes incurred as a result of a circular flow of cash -- distribution of cash and immediate re-contribution of cash -- that was disregarded for U.S. tax purposes properly creditable under Section 901); Rev. Rul. 83-142, 1983-2 C.B. 68 (same); I.R.S. Field Serv. Adv. 003803 (June 3, 1996) (updated on Jan. 31, 2006) (same).

11See, e.g., I.R.S. Gen. Couns. Mem. 34,109 (Apr. 25, 1969) (foreign government increased taxable income (and resulting foreign taxes) on audit of foreign subsidiary of U.S. company in a manner not recognized or otherwise accepted for U.S. tax purposes but resulting foreign taxes nonetheless deemed creditable under Section 901); I.R.S. Gen. Couns. Mem. 35,220 (Jan. 30, 1973) ("It seems clear that the subsidiary, having paid the foreign taxes which were imposed on it, including the foreign taxes on the misallocated income, is entitled to a credit for those taxes.").

12See, e.g., Chief Couns. Adv. 2013-49-015 (Sept. 16, 2013)("Transactions that are generally disregarded for U.S. tax purposes because they occur between entities that are disregarded as separate entities from one another may nevertheless significantly impact foreign taxes. For example, a foreign [disregarded entity] that is party to a transaction may be treated for foreign tax purposes as a corporation separate from its counterparty in the transaction.").

13 The Government has permitted taxpayers to claim credits for foreign taxes imposed on income or transactions not recognized for U.S. tax purposes because the foreign tax credit regime has built-in limitations under Section 904 that defer or deny the use of credits in such cases. See I.R.S. Chief Couns. Adv. 2002-23-022 (Mar. 1, 2002) (Felker,Foreign Tax Credit Branch Chief) (recognizing that nothing in Section 901 precludes credits for taxes imposed on "items of income that constitute U.S. source income, or items that are not taxable, under the Internal Revenue Code" but that "the foreign tax credit limitation under section 904 provides the mechanism to limit the allowable foreign tax credit to the U.S. tax on the taxpayer's foreign source income.").

14 In IES , the taxpayer purchased and sold the ADRs within hours while the U.S. and European markets were closed to lock in the price, but was deemed to have held the shares over the dividend date because the sale did not settle until after the record date of the dividend. 253 F.3d at 352, 355. In Compaq, special NYSE settlement terms were used such that the effective purchase date of the shares was prior to the record date of the dividend. 277 F.3d at 780, 787.

15 In fact, the Government initially promulgated and then rescinded a requirement in the voluntary tax regulations to demonstrate a non-tax business purpose to enter a foreign jurisdiction, instead adding the following statement: "A taxpayer is not required to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax." Treas. Reg. § 1.901-2(e)(5)(i); (see also JA49627-29).

16 The economic substance of the Loan has nothing to do with the economic substance of the Trust Transaction -- both, to be clear, had economic substance -- because the tax consequences of separable, genuine, and substantive elements of a transaction are preserved even if another portion of the transaction lacks economic substance. See supra p. 59 (citing Coltec and ACM P'ship).

17 PwC was well aware of Ruble's expulsion from Sidley when it reaffirmed its advice on STARS in 2004. (JA622-23; JA1187.)

 

END OF FOOTNOTES
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