News & Articles


04 / 01 / 2013

Bank of NY Mellon Corp. v. IRS, 2013 U.S.Tax Ct. LEXIS 2 (2013)
In a case it says is of first impression, the United States Tax Court has found that a STARS (Structured Trust Advantaged Repackaged Securities) transaction that was once shopped around by KPMG and Barclays lacked economic substance, and because it did, the bank and its subsidiary affiliated group are not entitled to the claimed foreign tax credits, the claimed deductions, or the foreign-source income treatment put forth on its returns.  The Tax Court rejected the banks's argument that it had entered into STARS to obtain "low-cost funding" for its banking business and that it reasonably expected to earn a "pre-tax profit" from STARS, and further rejected the argument that the US foreign tax credit was "intended" for transactions like STARS.  As stated, the Tax Court held:
"The STARS transaction was structured to meet the relevant requirements in the Code and the regulations for claiming the disputed foreign tax credits.  The STARS transaction in essence, however, was an elaborate series of pre-arranged steps designed as a subterfuge for generating, monetizing and transferring the value of foreign tax credits among the STARS participants."
Later, the Tax Court stated, "The disputed foreign tax credits were generated by circulating income through the STARS structure.  In contrast, the loan was not necessary for the STARS structure to produce the disputed foreign tax credits.  It is the use of the STARS structure then that is relevan and that we test for economic substance."  The Court looked at whether the BNY's use of the STARS structure had OBJECTIVE economic substance, based on Second Circuit precedent (Long Term Capital Holdings).  According to the Tax Court, BNY did not have reasonable expectation that it would make a non-tax economic profit from using the STARS structure (in part because it reduced profitability by adding substantial transaction costs).  When turning to the subjective prong of the economic substance analysis, the Court examined whether BNY had a legitimate non-tax business purpose for use of the STARS transaction.  Noting that the "loan" was not "low cost"; that it was "significantly overpriced and required BNY to incur substantially more transaction costs than a similar financing available in the marketplace, and that BNY's true motivation was tax avoidance. 
The STARS transaction was said to have been promoted by Barclays and KPMG to various US banks.  It was represented as a below market loan that further required a UK counterparty and a certain trust holding structure.  The trust structure was set up to receive income producing assets.  The below-market cost is then achieved by having the UK counter party "share" in the UK tax benefits through an offset to the cost of the loan.  The trust then generates UK tax, and thus generates foreign tax credits that could be used by the subscribing bank (in this case BNY) to offset its US tax liabilities. 
In the opinion, the Tax Court walks through the step-by-step approach taken with respect to the STARS tranaction that was entered into by and between BNY and Barclays, in November, 2001.  BNY and its existing subsidiaries used SPEs to carry out the STARS transaction.
Step 1.  Funding of REIT subsidiary.  BNY contributed $6.46 billion of assets (i.e. participating interests in residential and commercial and consumer loans) to an existing BNY subsidiary, BNY REIT Holdings, LLC treated as a corporation for US tax purposes, and assumed $2.55 billion of BNY's liabilities in connection with the contribution. 
Step 2:  BNY then organizes a new SPE, BNY Investment Holdings, LLC (Delaware LLC), called InvestCo, electing it to be taxed as a corporation for US tax purposees, making it part of BNY's affiliated group, and capitalizing it with $10.409 billion of assets consisting of BNY assets and BNY Real Estate Holdings, LLCs common stock (the REIT share) with a stated value of $3.95 billion (STARS assets), and in exchange, also assumed BNY liabilities, and issued a 100% ownershi interest in the new company to REIT Holdings.
Step 3:  BNY then organizes BNY Delaware Funding, LLC (DelCo), which elected partnership tax treatment for US tax purposes.  The new SPE Investco from Step 2 then capitalizes it by contributing $9.243 billion worth of the STARS assets, and in exchange it assumes BNY liabilities, and issues two classes of shares (DelCo class 1 and DelCo class 2) worth $6.628 billion.  The class 1 shares had all of the voting rights in DelCo, the class 2 had the right to receive 99% of DelCo's distributions.  DelCo class 1 shareholders had the excclusive right to appoint DelCo's managers, and DelCo's income was distributable in the absolute discretion of DelCo's managers.
Step 4:  BNY then forms the BNY STARS Trust as a common law trust, with the trust itself authorized to issue class A, B, C and D units.  These units were contractually entitled to receive monthly distributions in the following order:  Class A unit holders, 1% of trust DNI, Class D to trust DNI equal to $25 million X 1-month LIBOR plus 415 basis pints x .78, Class B then entitled to 99% of remaining DNI if the Class C was in issue or all of the remaining DNI if class C unit was not in issue.  The class C unit holder was not entitled to the remaining trust DNI unless a default occurred.  At that point, the SPE transferred the remaining STARS assets (approximately $1.2 billion) and the DelCo class 2 shares to the trust in exchange for the class A units and the class B unit, which had stated values of $6.3 billion, and $1.494 billion, respectively. 
Step 5:  BNY then organized NewCoFunding, LLC with Investco as its only member.  NewCo elected partnership tax treatment for US tax purposes.  Investco contributed 49% of the Class A units to NewCo, in exchange for a membership interest with a $3.089 billion stated value, and Investco then distributed 1% of its NewCo interest to REIT Holdings.
By these steps, $7.86 billion in net assets were moved into DelCo and the trust.
At that point, through a series of additional transactions and agreements, Barclays purported to loan $1.5 billion. 
Notably, when the bank also claimed that the "disputed tax benefits" were what Congress intended, in establishing the foreign tax credit, the Tax Court said, not so fast.  There the Tax Court had this to say,
"The United States taxes income of its citizens, residents, and domestic entities on a worldwide basis.  A US corporation must include foreign source income in its US taxable income even though that income may also be subject to foreign tax.  Congress enacted the foreign tax credit to alleviate double taxation arising from foreign business operations (cites omitted).  Congress intended the foreign tax credit to neutralize the effect of US tax on the business decision of where to conduct business activities most productively. 56 Cong. Rec. App. 677-78 (1918)(statement of Rep. Kitchin).  The enactment of the foreign tax credit was also informed of fairness.  See National Foreign Trade Council, Inc., International Tax Policy for the 21st Century, Dec. 15, 2011).  The STARS transation was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies.  The UK taxes at issue did not arise from any substantive foreign activity.  Indeed, they were produced through pre-arranged circular flows from assets held, controlled, and managed within the United States.  We conclude that Congress did not intend to provide foreign tax credits for transactions such as STARS."