A U.S. District court has determined that a United States–based bank, having been denied foreign tax credits for UK taxes paid in connection with a Structured Trust Advantaged Repackaged Securities (STARS) transaction that was held to be a sham, couldn’t deduct those taxes.
The U.S. District Court of Minnesota found that the bank had waived the issue by failing to raise it sooner — and that, even if it had been timely raised, the deduction nonetheless would have been disallowed under the sham transaction doctrine.
Note: For transactions entered into after March 30, 2010 — that is, after the time period involved in this case — the Health Care and Education Reconciliation Act added a section to the U.S. Tax Code to clarify the economic substance doctrine. Under that change, a transaction is treated as having economic substance under a conjunctive two-prong test only if, apart from federal income tax effects:
- The transaction changes the taxpayer’s economic position in a meaningful way, and
- The taxpayer has a substantial purpose for entering into the transaction. (That is, the taxpayer’s non-federal-income-tax purpose for entering into a transaction must be “substantial.”)
Facts of the case
A U.S. international banking and financial services holding company engaged in a complex STARS transaction with a large UK financial services company. As part of the transaction, the U.S. bank voluntarily subjected some of its income-producing assets to UK taxes by placing them in a trust with a UK trustee. The bank offset those UK taxes by claiming foreign tax credits on its U.S. returns.
The IRS disallowed the foreign tax credits on the ground that the STARS transaction was a sham. The case was tried before a jury, which decided that the larger STARS transaction consisted of two parts — the “trust structure,” which gave rise to the foreign tax credits, and the loan. It determined that the trust structure was a sham.
Sham transaction doctrine
Key in this case is the understanding that, in general, a transaction will be characterized as a sham if “it is not motivated by any economic purpose outside of tax considerations” (the business purpose test), and if it “is without economic substance because no real potential for profit exists” (the economic substance test). This sham transaction doctrine is a way for the IRS to look beyond technical compliance with the tax code to ascertain the real nature of a transaction. Once a transaction is found to be a sham, it is disregarded for federal tax purposes.
Two issues identified
After the jury determined that the STARS transaction was a sham, the court gave the two parties time to discuss the verdict and figure out next steps — basically, identify the issues that still had to be resolved before a judgment could be entered. The parties identified these two issues:
- Was the U.S. bank subject to a negligence penalty in connection with its claim of foreign tax credits, and
- Should the loan portion of the STARS transaction be disregarded as a sham?
The court then directed the parties to submit a proposed judgment. The U.S. bank instead submitted a letter asserting that there remained one final legal issue to be resolved: Could it deduct the foreign taxes it paid despite the fact that it couldn’t receive a credit for them?
The IRS contended that the bank had waived this issue and, regardless, wasn’t entitled to a deduction.
The court agreed that the issue had been waived. It asked the parties to identify every remaining legal issue that had to be resolved before it could enter judgment, and both the U.S. bank and the IRS explicitly agreed to only the two issues noted above. At no time during the briefing and resolution of those issues did the bank notify the court or opposing counsel that there were any other legal issues to be resolved before the judgment could be entered.
The bank was aware of the issue, the court noted, as it was pleaded in an amended complaint and mentioned in a trial brief. Thus, the court reasoned, while the failure to raise the issue immediately after the verdict could have been attributable to inadvertence, “it is impossible to believe that [the bank’s] subsequent months-long silence was unintentional.”
The court also agreed with the IRS that, even if the issue hadn’t been waived, the bank wasn’t entitled to claim any tax benefits flowing from it because the trust structure was disregarded as a sham.
The bank argued that courts don’t necessarily disregard all aspects of a transaction found to be a sham, noting that, in some cases, a taxpayer can claim tax benefits on the basis of “separable, economically substantive elements” of a sham transaction. While the court agreed in principle, it found that, in this case, the trust structure was found to be a sham, and the foreign tax payments were directly connected with and made in furtherance of the trust structure.
All arguments foreclosed by sham doctrine
The bank also asserted a number of other arguments in support of its entitlement to the deduction, but the court found that these arguments were foreclosed by the sham transaction doctrine.