The Supreme Court declined to review an appeals court ruling that the “trust” component of a Structured Trust Advantaged Repackaged Securities (STARS) transaction lacked economic substance.
Background: The U.S. Court of Appeals for the First Circuit had found that the trust transaction, which involved the participating bank transferring assets to a disregarded foreign trust and claiming credits for foreign taxes paid:
- Had no legitimate business purpose, and
- Absent the generation of foreign tax credits, provided no objective economic benefit.
To determine whether a transaction has economic substance, courts usually make a two-pronged factual inquiry:
- Was the taxpayer motivated by no business purpose (other than getting tax benefits) in entering into the transaction (subjective test)?
- Did the transaction have objective economic substance — that is, was there a reasonable possibility of a profit (objective test)?
The economic substance doctrine allows the government to look beyond technical compliance with the Internal Revenue Code to ascertain the real nature of the transaction at issue.
Foreign tax credit
Both the United States and foreign countries may tax the foreign-source income of U.S. taxpayers. To ease this double taxation burden, the tax code permits most U.S. taxpayers who pay income taxes to a foreign country to either deduct those taxes from gross income for U.S. purposes or credit them dollar for dollar against their U.S. income tax liability on foreign-source income.
Facts of the recent case
Sovereign Bancorp, Inc., later known as Santander Holdings USA, Inc., engaged in a STARS transaction promoted by the U.K.-chartered Barclays Bank PLC. As described by the court, the transaction featured Barclays receiving substantial benefits under U.K. tax laws and lending funds to U.S. banks at a lower cost than otherwise might be available to them.
As part of the STARS transaction, Sovereign created a trust to which it contributed $6.7 billion of income-generating assets. The trustee of the trust was made a U.K. resident so that the trust’s income was subject to U.K. income tax at a 22% rate. The trust income was also subject to U.S. income tax and was attributed to Sovereign. Sovereign paid the U.K. taxes and then claimed a foreign tax credit in calculating its U.S. income tax liability. This component of the transaction was referred to by the court as the “trust transaction.”
Over the course of a year, Barclays acquired a $1.15 billion interest in the trust, which it was required to sell back to Sovereign, for $1.15 billion, at the end of the transaction. Sovereign treated the $1.15 billion as a loan and claimed interest deductions on it. The trust engaged in certain actions that generated a U.K. tax benefit for Barclays in exchange for which Barclays made a monthly payment equal to half of the amount of U.K. taxes paid by Sovereign on the trust’s income that Sovereign netted against its interest obligation on the purported loan.
The IRS disallowed foreign tax credits claimed by Sovereign for 2003, 2004 and 2005. The tax agency claimed that the Barclays payment was effectively a rebate of the U.K. taxes paid, in that it relieved Sovereign of half the burden of its U.K. taxes. It further claimed that the STARS transaction as a whole was a sham without economic substance. Sovereign sued to recover $234 million in federal income taxes, penalties and interest.
Lower court decision
In 2013, the Massachusetts U.S. District Court granted Sovereign partial summary judgment that the Barclays payment should be accounted for as revenue to Sovereign in assessing whether Sovereign had a reasonable prospect of profit in the STARS transaction.
Sovereign then moved for summary judgment on its claims for refunds of taxes paid in 2003, 2004 and 2005, as well as deficiency interest assessed by the IRS. The district court again sided with Sovereign, upholding the legitimacy of both the trust and loan transactions and allowing Sovereign to claim interest deductions and foreign tax credits for the U.K. taxes paid. The court also found that, since the credits and interest deductions were properly claimed, Sovereign should not be assessed penalties.
The First Circuit found that the district court had committed reversible error and that the government was entitled to summary judgment as to the economic substance of the trust transaction.
The court noted that it didn’t matter whether the Barclays payment was characterized as a rebate or income because, regardless, the trust transaction itself didn’t have a reasonable prospect of creating a profit without considering the foreign tax credits and thus was not a transaction for which Congress intended to give such a benefit.
The First Circuit found that the transaction was shaped solely by tax avoidance features, lacked a bona fide business purpose, and was “profitless,” in that the purported profit from the Barclays payment was more than negated by the costs of the transaction. The entire function of the trust transaction was exposure to U.K. taxation in order to generate foreign tax credits, which does not “advance the Tax Code’s interest in providing foreign tax credits in order to encourage business abroad or in avoiding double taxation.”
The First Circuit also found it telling that the trust transaction lacked any real economic risk, as Barclays and Sovereign both had contractual remedies and took other steps to minimize such risk. It also noted that Sovereign’s U.K. tax liability was artificially generated through a series of “circular cash flows” through the trust, which, as noted above, existed just to generate the desired tax effect.
Accordingly, the First Circuit reversed the district court’s decision as to the economic substance of the trust transaction and the foreign tax credits claimed. The Supreme Court refused to review the First Circuit’s decision.