Tax benefits from structured financial transaction denied for lack of economic substance

Friday 1 March 2013

The US Tax Court has disallowed foreign tax credits (FTCs), expense deductions, and foreign-source income treatment from a structured financial transaction based on the economic substance doctrine.

The case involved a US banking company and its affiliated group that entered into a complex series of transactions, referred to as the Structured Trust Advantaged Repackaged Securities transaction (the STARS transaction), with a financial services company headquartered in the United Kingdom. The STARS transaction was developed by an international accounting firm.

The US Tax Court, in applying the economic substance doctrine to the present case, followed the law of the US Court of Appeals for the Second Circuit, in which an appeal of the present case would be heard.
The US Tax Court stated that, in analyzing the economic substance of a transaction, the Court of Appeals for the Second Circuit evaluates both the objective prong of the test (i.e. whether a transaction created a reasonable opportunity for economic profit exclusive of tax benefits) and the subjective prong of the test (i.e. whether a taxpayer had a legitimate non-tax business purpose) as factors to consider in an overall inquiry, rather than as discreet prongs of a "rigid two-step analysis", i.e. a finding of a lack of either economic profits or a non-tax business purpose can be but is not necessarily sufficient for a court to conclude that a transaction is invalid.

As the first step in the inquiry, the US Tax Court bifurcated the STARS transaction and decided to focus on the STARS structure. The US Tax Court explained that the disputed FTCs were generated by circulating income through the STARS structure, and that the STARS loan was not necessary for the STARS structure to produce the FTCs.

The US Tax Court held that the STARS structure lacked objective economic substance because it did not increase the profitability of the STARS assets, and, to the contrary, it reduced their profitability by adding substantial transactional costs, e.g. professional service fees and foreign taxes. The US Tax Court found that the STARS assets would have generated the same income regardless of being transferred to the trust because the main activity of the STARS structure was to circulate income.

The US Tax Court further held that the STARS structure lacked subjective economic substance, rejecting the claim that the STARS structure was used to obtain a low-cost loan from the financial services company. The US Tax Court held that the true motivation was tax avoidance based on its findings that the STARS structure did not bear any reasonable relationship to the loan in terms of banking, commercial, or business functions, and that the STARS loan was not low cost and instead was significantly overpriced and required to incur substantially more transaction costs than a similar loan available in the marketplace.
Then, the US Tax Court held that, considering the above-mentioned findings, the STARS transaction would still lack economic substance even if the STARS structure and the loan were evaluated as an integrated transaction. The US Tax Court stated that any income from investing the loan proceeds was not income arising from the integrated STARS transaction, but rather from a separate and distinct transaction, and therefore any such income, and the expectation of such income, should be excluded from the economic substance analysis.
The US Tax Court determined that the STARS transaction should be disregarded for US tax purposes because it lacked economic substance. Accordingly, the US Tax Court denied the claimed FTCs for the UK taxes paid on trust income, as well as the deductions for the expenses related to the STARS transaction, including the UK taxes for which FTCs were denied.

In addition, the US Tax Court rejected the argument that the US Congress intended to provide the FTC for transactions like STARS. The US Tax Court stated that Congress enacted the FTC to alleviate double taxation arising from foreign business operations. The US Tax Court held that the UK taxes at issue did not arise from any substantive foreign activity, but instead were produced through prearranged circular flows from assets held, controlled, and managed within the United States.

The US Tax Court also rejected the position that the income from the trust is treated as foreign-source income under a "resourcing" provision in article 23(3) of the former US-UK treaty. The US Tax Court held that the income should be treated as being derived within the United States, and thus the US-UK treaty was not applicable.

In the present case, the US Tax Court considered the foreign taxes paid in furtherance of the invalidated transaction as expenses in calculating the pre-tax profits of the transaction. The US Courts of Appeals for the Fifth and Eighth Circuits have held to the contrary.

The present case concerned the 2001 and 2002 taxable years, and thus predated the codification of the economic substance doctrine in 2010 as section 7701(o) of the US Internal Revenue Code. As a result, section 7701(o) was not directly applied by the US Tax Court, although the court did note that the legislative history to section 7701(o) supported the bifurcation approach used in the court's analysis. 
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