Foreign Tax Credits - Planning and Pitfalls

Ciaramella, Francis 4/21/2014
For Educational Use Only

ATTACHMENTS, VCVG0919 ALI-CLE 197
2014 Thomson Reuters. No claim to original U.S. Government Works. 1
VCVG0919 ALI-ABA 197
American Law Institute - American Bar Association Continuing Legal Education
The American Law Institute Continuing Legal Education
February 26, 2014
Foreign Tax Credits: Planning and Pitfalls
*197 ATTACHMENTS
Submitted by Jerald David August
Fox Rothschild LLP
Philadelphia, Pennsylvania and West Palm Beach, Florida
Copyright (c) 2014 The American Law Institute
TABLE
TABULAR OR GRAPHIC MATERIAL SET FORTH AT THIS POINT IS NOT DISPLAYABLE
End of Document 2014 Thomson Reuters. No claim to original U.S. Government Works.
FOREIGN TAX CREDITS: PLANNING AND PITFALLS -..., VCVG0919 ALI-CLE 215
February 26, 2014
*215 FOREIGN TAX CREDITS: PLANNING AND PITFALLS - SLIDE PRESENTATION
Richard E. Andersen
WilmerHale
New York, New York
Copyright (c) 2013 Richard E. Andersen
*216 What's At Stake?
Minimizing combined foreign and U.S. tax burdens
Managing U.S. substantive and procedural requirements
*217 Purpose of Foreign Tax Credit
Designed to mitigate international double taxation without compromising capital export neutrality principle
Intended to divide stable worldwide tax liability between U.S. and foreign country
Example of the FTC in Action
Facts
USCO earns $300 of royalty income, $100 from abroad
Foreign royalty income bears 10% withholding tax
USCO is a 35% US taxpayer, implying a $105 tax liability
Calculation
$70 US tax on US royalty
$35 tentative US tax on foreign royalty
$10 foreign tax deducted from $35 tentative US tax
$95 US tax + $10 foreign tax = $105
*218 I: The Foreign Tax Credit Rules
The 3 Golden Rules of the U.S. Foreign Tax Credit
The U.S. will not subsidize a foreign tax system with the foreign tax credit
The U.S. will oppose distortions of economic activity to increase the credit
The U.S. will apply its own rules and definitions to credit-related concepts
*219 The Foreign Tax Credit Question
Can I prove I paid a tax on foreign income and credit it all this year?
The Foreign Tax Credit Question
*220 Prove
Forms 1116 and 1118
Foreign tax receipt or return
Effect of foreign tax redeterminations
*221 I
Who is the technical taxpayer?
general rule: legal liability for tax
presumption: payment implies liability
Guardian Industries
technical taxpayer regulation
Section 909
What is the technical taxpayer?
Foreign law governs facts; U.S. law governs consequences
*222 Paid
Payment vs. accrual
Direct credit
Indirect credit
The Direct Foreign Tax Credit: In General
Subject to limitations (e.g., IRC 904), foreign income taxes paid or accrued by a U.S. taxpayer who is legally obligated to
pay those taxes may be credited against that taxpayer's tentative U.S. income tax liability (IRC 901)
*223 The Direct Foreign Tax Credit: The Branch/Subsidiary Anomaly
US corporation gets a direct credit for foreign income taxes paid by its branch (including partnerships and disregarded
entities)
US corporation gets no direct credit for foreign income taxes paid by its 100%- owned subsidiary (parent didn't pay
the tax)
The Indirect Foreign Tax Credit: In General
Foreign income taxes paid or accrued by a foreign subsidiary are deemed paid by the US parent for credit purposes
(IRC 902)
Subsidiary
Direct: at least a 10% voting interest (including through partnership)
Indirect: at least a 10% direct voting interest, if US parent owns at least 5% indirectly
*224 The Indirect Foreign Tax Credit: Requirements
Parent and subsidiary must be C corporations
Earnings that bore the foreign tax must be recognized by parent as a dividend
earnings and profits allocations
pre-1987/post-1986 pools
basket allocations
foreign tax allocations
Dividend grossed up by credit (IRC 78)
Credit for Withholding Taxes (IRC 901(k), (l)) (1)
No credit for dividend withholding taxes if recipient holds stock for fewer than 16 days during the 30-day period beginning
15 days before the record date (46 days within the 90-day period beginning 45 days earlier, in the case of some preferred
dividends)
The periods are tolled while the taxpayer is hedged with respect to its holding
*225 Credit for Withholding Taxes (IRC 901(k), (l)) (2)
AJCA 2004 introduced a similar rule for non-dividend withholding taxes
Limited to taxes on income derived from property
Dealer exception for net basis taxes
*226 Tax (1)
Compulsory payment
SPIA regulations
Foreign sovereign taxing authority
No specific economic benefit
Allocation requirement
Soak-up taxes
Tax (2)
Structured passive investment arrangements
Dedicated SPV earns exclusively passive income and pays a foreign levy
US party
US party's share of foreign levy exceeds its projected FTCs if the SPV's assets were owned by the US party
Counterparty subject to local net taxation is anticipated to receive a foreign tax benefit from the arrangement
Inconsistent US and local treatment of the arrangement
Tier I examination issue
Foreign
Only taxes on aggregate foreign income are creditable
Source rules in Code, Regulations, cases
Possible discontinuities
*228 IRC 904(h) (formerly (g))
U.S.-owned foreign corporations
50% ownership by U.S. persons (IRC 318 and 958 apply)
Interest, dividends, Subpart F and QEF income sourced by reference to underlying earnings or income
Overall Foreign Losses (IRC 904(f))
OFL: excess of foreign losses over allocable deductions (as modified)
Subsequent foreign income re-sourced to the U.S. to recapture OFL (up to 50% of foreign income)
Recapture upon disposition
*229 Overall Domestic Losses (IRC 904(g))
Enacted by AJCA, effective for post-2006 tax years
ODL: domestic loss (i) in excess of allocable deductions (ii) carried back to offset foreign-source income of a prior year
Subsequent domestic income re-sourced abroad to recapture ODL
*230 Income
Must be predominantly like a U.S. income tax
Likelihood of reaching net gain:
Realization requirement
Gross Receipts requirement
Net Income requirement
*231 Credit
Credit vs. deduction
Excluded taxes
Excluded taxpayers
Bad conduct exclusions
Section 901(m) exclusion for covered asset acquisitions
*232 The Saga of Tom the Tax Director
Time: Somewhere in the 1960s
Place: Bigville, USA, home of international widget manufacturer Bigco
Every year, Bigco earns $10MM from US sales, $8MM from local sales by its German subsidiaries, and $2MM from
interest on its working capital account with Prussiabank, a German commercial bank
Bigco's Effective Tax
US Tax Rate

50%

German Tax Rate

60%

Foreign Income

$10MM

US Tax on Foreign Income

$5MM

German Tax on Sales Income

$4.8MM

German Tax on Interest Income

$1.2MM

Excess Limitation (Credit)

($1MM)

*233 Tom's Problem
One day, Tom came back from the CFO's office, where his boss had dressed him down about Bigco's worldwide effective
tax rate.
What could Tom do?
Tom's Idea
Let's move Bigco's working capital account from Prussiabank to Beachbank, a leading commercial bank in the Cayman
Islands!
How did this help?
*234 Bigco's New Effective Tax
US Tax Rate

50%

German Tax Rate

60%

Foreign Income

$10MM

US Tax on Foreign Income

$5MM

German Tax on Sales Income $4.8MM

Cayman Tax on Interest Income

$0MM


$0.2MM

Tom's Reward
Tom got a big raise and a chance to audit Bigco's account at Beachbank for ten days every February
But storm clouds were gathering ...
*235 Tom's Distress
Congress enacted a separate basket for interest, requiring the credit limitation to be computed separately for (i) interest
and (ii) other income
What effect did this have on Bigco?
Bigco's Very New Effective Tax
US Tax Rate

50%

German Tax Rate

60%

Foreign Income

$10MM

US Tax on Sales Income

$4MM

US Tax on Interest Income

$1MM

German Tax on Sales Income

$4.8MM

Cayman Tax on Interest Income

$0MM


($0.8MM)

*236 All (Pre-2007 Tax Years)
Baskets
Passive
High-tax interest
Financial
Shipping
10/50
DISC
FSC 1 and FSC 2
General
Special rules
High-tax kickout
Active rents/royalties
Export interest
Look-through rules
Capital gains spread
Special oil & gas regime
All (Post-2006 Tax Years)
Baskets
Passive Category
Passive
DISC, both FSC
High-tax interest
General Category
Shipping, General
10/50 disappears (look-through rule)
Financial income can be either
Special rules
High-tax kickout
Active rents/royalties
Export interest
Look-through rules
Capital gains spread
Special oil & gas regime
This Year
Carryover periods
Pre-AJCA: 2 back, 5 forward
Post-AJCA: 1 back, 10 forward
Effective for any year to which any foreign taxes could be carried prior to AJCA
Special refund period
*238 Circular 230 Notice
Any U.S. federal tax advice included herein was not intended or written to be used, and cannot
be used, for the purpose of (i) avoiding U.S. federal tax-related penalties or (ii) promoting,
marketing or recommending to another party and tax-related matter addressed herein.
RELEVANT CASES, VCVG0919 ALI-CLE 115
February 26, 2014
*115 RELEVANT CASES
Submitted by Jerald David August
Fox Rothschild LLP
(c) 2014 Thomson Reuters. No Claim to Orig. US Gov. Works.
*116 112 Fed.Cl. 543, 112 A.F.T.R.2d 2013-6168, 2013-2 USTC P 50,517
(Cite as: 112 Fed.Cl. 543)
United States Court of Federal Claims. SALEM FINANCIAL, INC., Plaintiff, v. UNITED STATES, Defendant.
No. 10-192T
Filed: September 20, 2013
Background: Bank, which was subsidiary of United States taxpayer involved in complex financial transaction known as
STARS (Structured Trust Advantaged Repackaged Securities), brought action against United States, seeking tax refund in
relation to STARS transaction.
Holdings: The Court of Federal Claims, Wheeler, J., held that:
(1) bifurcating trust and loan components of transactions was appropriate;
(2) trust component was sham structure;
(3) loan component was sham structure;
(4) viewed as single, integrated transaction, trust and loan components constituted sham structure;
(5) advice by transaction's marketer and law firm it recommended was based on unreasonable and unsupported assumptions;
(6) bank did not reasonably rely on marketer's or firm's advice;
(7) transaction fell within statutory definition of tax shelter; and
(8) bank did not act with reasonable cause or in good faith in its tax treatment of transaction.
Ordered accordingly.
West Headnotes
[1] Internal Revenue 220 5112
220 Internal Revenue
220XXVIII Refunding Taxes
220XXVIII(B) Actions for Refunds
220XXVIII(B)9 Trial, Judgment and Review
220k5111 Review
220k5112 k. Scope of review in general. Most Cited Cases
Tax refund suit is a de novo proceeding, not an appellate review of the administrative decision that was made by the IRS,
and thus, in conducting its de novo review, the Court of Federal Claims gives no weight to subsidiary factual findings made
by the IRS in its internal administrative proceedings.
220XXVIII(B)8 Evidence
220k5075 Presumptions and Burden of Proof
220k5079 k. Overpayment. Most Cited Cases
Internal Revenue 220 5084
220k5082 Weight and Sufficiency
220k5084 k. Overpayment. Most Cited Cases
*117 Plaintiff in a tax refund suit bears the burden of proving that it has overpaid its taxes for the year in question in the
exact amount of the refund sought; this burden includes both the burden of going forward and the burden of persuasion, and
it must be met by a preponderance of the evidence.
220k5082 Weight and Sufficiency
220k5083 k. In general. Most Cited Cases
In order to fully or partially prevail in a suit for a tax refund, the plaintiff must demonstrate, by a preponderance of the
evidence, its entitlement to the specific amount of the tax refund at issue.
220V Income Taxes
220V(X) Income from Within and Without the United States
220V(X)2 Income from Sources Without the United States
220k4098 Foreign Tax Credit
Purpose of the foreign tax credit is to allow taxpayers to avoid double taxation on foreign income, and thus to neutralize
the effect of United States tax on the business decision of where to conduct business activities most productively. 26 U.S.C.A.
27, 901.
220V Income Taxes
Because the purpose of the foreign tax credit is to permit substantive business decisions to be made largely independent of
the tax consequences of the United States' worldwide system of taxation, a taxpayer may structure its business transactions so
as to minimize its tax liability. 26 U.S.C.A. 27, 901.
220V Income Taxes
Even if a transaction complies literally with the provisions of the Internal Revenue Code, it does not necessarily follow that
Congress, in enacting the foreign tax credit, intended to cover every foreign transaction and allow a tax benefit; instead, the
determinative question when assessing whether a party is entitled to a particular tax benefit is whether what was done, apart
from the tax motive, was the thing which the statute creating the benefit intended. 26 U.S.C.A. 27, 901.
*118 220 Internal Revenue
220V Income Taxes
220V(A) In General
220k3071 k. Substance or form of transaction. Most Cited Cases
Internal Revenue 220 4616.1
220XXI Assessment of Taxes
220XXI(C) Evidence
220k4616 Presumptions and Burden of Proof
220k4616.1 k. In general. Most Cited Cases
Economic substance doctrine provides that, technical compliance with the tax code notwithstanding, the taxpayer bears the
burden of demonstrating that a given transaction carries both (1) the objective possibility of realizing a pre-tax profit, i.e.,
objective economic substance, and (2) a non-tax business purpose, i.e., subjective economic substance.
220V Income Taxes
220V(A) In General
Economic substance doctrine seeks to distinguish between structuring a real transaction in a particular way to obtain a tax
benefit, which is legitimate, and creating a transaction to generate a tax benefit, which is illegitimate.
220III Minimization, Avoidance or Evasion of Liability
220V Income Taxes
220V(A) In General
While taxpayers are entitled to structure their transactions in such a way as to minimize tax, when the business purpose
doctrine is violated, such structuring is deemed to have gotten out of hand, to have been carried to such extreme lengths that
the business purpose is no more than a facade.
220V Income Taxes
220V(A) In General
Business purpose doctrine reduces the incentive to engage in essentially wasteful activity, and in addition helps achieve
reasonable equity among taxpayers who are similarly situated, in every respect except for differing investments in tax avoidance.
220V Income Taxes
*119 220k4098 Foreign Tax Credit
Economic substance doctrine applies in equal force to foreign tax credits, and such application is fully consonant with the
purpose behind such credits: to establish neutrality through the elimination of double taxation that would arise in the absence
of foreign tax credits. 26 U.S.C.A. 27, 901.
220V Income Taxes
There is no foreign tax credit exception to the economic substance doctrine. 26 U.S.C.A. 27, 901.
220V Income Taxes
220V(A) In General
Inquiry into whether a challenged transaction had objective economic substance focuses on whether the transaction created
a reasonable opportunity of making a profit from the transaction.
220V Income Taxes
220V(A) In General
Inquiry into whether a challenged transaction had subjective economic substance focuses on whether the taxpayer's sole
subjective motivation is tax avoidance, including whether the transaction is shaped solely by tax-avoidance features.
220V Income Taxes
220V(A) In General
Under the economic substance doctrine, the transaction to be analyzed is the one that gave rise to the alleged tax benefit,
even if it is part of a larger set of transactions or steps; in other words, the requirements of the doctrine are not avoided simply
by coupling a routine transaction with a transaction lacking economic substance, as a contrary application would undermine
the flexibility and efficacy of the doctrine.
220V Income Taxes
220V(A) In General
First step in the economic substance inquiry is to identify the transaction to be analyzed.
220V Income Taxes
Links between trust and loan components of STARS (Structured Trust Advantaged Repackaged Securities) transaction were
artificial, and further, disputed foreign tax credits were attributable solely to trust, and thus bifurcating transaction and examining
trust structure for economic substance, independent of loan, was appropriate in participating bank's tax refund suit; transaction
called for bank's parent, as United States taxpayer, to establish trust containing $6 billion in revenue-producing bank assets, from
which monthly revenues were cycled through United Kingdom (U.K.) trustee, and, while revenue was immediately returned
to trust, UK tax credits thus generated were shared 50/50 between parent and trustee, while $1.5 billion loan from trustee to
parent was not necessary to objective of generating foreign tax credits, but trustee's monthly Bx payment to parent represented
parent's share of tax credits and had effect of reducing interest cost of loan. 26 U.S.C.A. 27, 901.
220V Income Taxes
Trust component of STARS (Structured Trust Advantaged Repackaged Securities) transaction had no non-tax business
purpose, and instead its sole function was to self-inflict United States-sourced income by bank in order to reap U.S. and
United Kingdom (U.K.) tax benefits, and thus it constituted sham structure that would be disregarded for federal tax purposes;
transaction consisted of three principal circular cash flows, in which (1) bank caused entity to make monthly distributions to
trust, which U.K. trustee then immediately returned to entity, thus subjecting income to U.K. tax without changing its substance
or character, (2) bank caused trust to deposit predetermined amount into blocked account, and then to withdraw that amount
immediately, thus allowing trustee to claim U.K. tax loss for purported reinvestment of trust's income, and (3) bank cycled tax
through U.K. taxing authority, then to trustee, and then back to itself. 26 U.S.C.A. 27, 901.
220V Income Taxes
220V(A) In General
Circular cash flow, as a strong indication that a transaction lacks economic substance for federal tax purposes, is a set of
offsetting cash entries that lack economic importance.
220V Income Taxes
220V(A) In General
*121 In evaluating a transaction for pre-tax profit, a court must determine which aspects are real economic effects and
thus non-tax items, and which are tax effects, by isolating tax effects and examining the aspects of the transaction that are
economically substantive absent the tax.
220V Income Taxes
220V(A) In General
Economic substance inquiry focuses on whether there was a reasonable possibility of making a profit from the transaction,
as judged from the viewpoint of a reasonably prudent investor looking at the transaction prospectively.
220V Income Taxes
220V(A) In General
Under both the economic substance and substance-over-form doctrines, the creation and use of sham structures to achieve
tax benefits are disregarded for federal tax purposes.
220V Income Taxes
220V(A) In General
Sham structure that lacks a non-tax business purpose and is unreal or a bald and mischievous fiction must be disregarded.
220V Income Taxes
Loan component of STARS (Structured Trust Advantaged Repackaged Securities) transaction was not structured to make
profit, but instead was devised to provide bank with pretext for purported business purpose for engaging in sham trust
transaction, and thus loan constituted sham structure that would be disregarded for federal tax purposes; agreement between
bank and its United Kingdom (U.K.) trustee was that loan rate would be based on 30-day London Interbank Offered Rate
(LIBOR), and either party had right to terminate transaction within 30 days, so that only reason to continue loan for five-year
life of STARS was because of purported low-cost funding, which was entirely produced by tax benefit, there was no evidence
that bank took into account use of loan proceeds in deciding whether to enter transaction, and contemporaneous documents
showed that bank, trustee, and transaction's marketer considered profit on STARS to come solely from trustee's rebate of U.K.
taxes, with bank then claiming foreign tax credits for amount rebated. 26 U.S.C.A. 27, 901.
*122 220V Income Taxes
Viewed as single, integrated transaction, trust and loan components of STARS (Structured Trust Advantaged Repackaged
Securities) transaction involving bank, as United States taxpayer, lacked any economic reality, and thus transaction constituted
sham structure that would be disregarded for federal tax purposes; by creating trust arrangement with nothing but circular cash
flows, and momentarily placing funds in hands of United Kingdom (U.K.) trustee before it was returned to trust, bank and
trustee artificially caused U.K. tax on U.S.-sourced revenue, in absence of any substantive economic activity occurring in U.K.,
while allowing bank and trustee to share benefits of foreign tax credits that resulted in a 51-percent rebate of trustee's Bx
payment to bank, and surprisingly low interest rate to bank on $1.5 billion loan from trustee was made possible solely because
of trust arrangement. 26 U.S.C.A. 27, 901.
220V Income Taxes
220V(A) In General
In applying the doctrine of substance over form to determine a transaction's substance for federal tax purposes, courts look
to the objective economic realities of a transaction, rather than to the particular form the parties employed.
220XIX Returns and Reports
220k4472 k. Necessity of return and effect of failure to make. Most Cited Cases
220XXI Assessment of Taxes
220XXI(A) In General
220XXIV Payment
220k4812 k. Duty and necessity of payment in general. Most Cited Cases
Federal tax system is primarily one of self-assessment, whereby each taxpayer computes the tax due and then files the
appropriate form of return along with the requisite payment.
220XXXI Penalties and Additions to Tax
220XXXI(B) Grounds and Amount
220k5219 k. Negligence. Most Cited Cases
Internal Revenue 220 5219.10
220k5219.10 k. Reasonable cause. Most Cited Cases
When a taxpayer underpays his taxes due to, inter alia, negligence or a substantial understatement of tax, the Internal
Revenue Code assesses penalties, except that the Code provides an absolute defense to accuracy-related penalties assessed for
an underpayment if it is shown that there was reasonable cause for such portion and that the taxpayer acted in good faith with
respect to such portion. 26 U.S.C.A. 6662(b)(1-2), 6664(c)(1).
220k5219 k. Negligence. Most Cited Cases
For purposes of an accuracy-related penalty, negligence is strongly indicated where a taxpayer fails to make a reasonable
attempt to ascertain the correctness of a deduction, credit, or exclusion on a return which would seem to a reasonable and
prudent person to be too good to be true under the circumstances. 26 U.S.C.A. 6662(b, c); 26 C.F.R. 1.6662-3(b)(1)(ii).
[30] Internal Revenue 220 5219.10
For purposes of an accuracy-related penalty, a taxpayer is not negligent when there is a reasonable basis for the position
taken; this reasonable basis standard is relatively high, and is not satisfied by a return position that is merely arguable or that
is merely a colorable claim. 26 U.S.C.A. 6662; 26 C.F.R. 1.6662-3(b)(1, 3).
Good faith reliance on professional advice may provide a reasonable basis for a tax treatment, so as to avoid the imposition
of an accuracy-related penalty, but such reliance must be objectively reasonable and taxpayers may not rely on someone with
an inherent conflict of interest. 26 U.S.C.A. 6662(b), 6664(c)(1); 26 C.F.R. 1.6662-3(b)(1, 3).
In the face of an accuracy-related penalty, the defense of reliance on professional advice prevails only if, under all the
circumstances, (1) the advice itself is reasonable and (2) the taxpayer's reliance thereon is reasonable. 26 U.S.C.A. 6662(b),
6664(c)(1); 26 C.F.R. 1.6662-3(b)(1, 3).
*124 220XXXI Penalties and Additions to Tax
In determining whether the professional advice relied upon by the taxpayer is reasonable, so as to avoid the imposition of
an accuracy-related penalty, courts look to whether the advice is based on accurate information and representations supplied
by the taxpayer, whether there was a reasonable investigation into the transaction, and whether it contains any unreasonable or
unsupported assumptions. 26 U.S.C.A. 6662(b), 6664(c)(1); 26 C.F.R. 1.6662-3(b)(1, 3).
220k5219.50 k. Abusive tax shelters. Most Cited Cases
Advice provided to bank by principal marketer of STARS (Structured Trust Advantaged Repackaged Securities) transaction
was based on unreasonable and unsupported assumptions, and thus bank's reliance on that advice was not reasonable and
imposing accuracy-related penalty in relation to bank's tax treatment of transaction was warranted; marketer touted transaction's
viability and profitability, including assurances that bank's concerns about whether IRS would find transaction to be sham were
unfounded and that, even if transaction was found to lack economic substance, bank would still be allowed to deduct United
Kingdom (U.K.) taxes incurred n transaction, which flew in face of accepted principle that transactions lacking in economic
substance would be disregarded for federal tax purposes. 26 U.S.C.A. 6662; 26 C.F.R. 1.6662-3(b)(1, 3).
Advice provided to bank by law firm recommended by principal marketer of STARS (Structured Trust Advantaged
Repackaged Securities) transaction was based on unreasonable and unsupported assumption that technical compliance with
United States tax law would allow IRS to give its imprimatur to economically meaningless transaction, and thus bank's reliance
on that advice was not reasonable and imposing accuracy-related penalty in relation to bank's tax treatment of transaction
was warranted; firm's tax opinion detailed similar STARS transaction, favorable opinions stated therein were largely pre-
fabricated and predetermined, and, similar to advice of marketer itself, firm's advice and opinion letters endorsed and advocated
promulgation of economically meaningless transactions. 26 U.S.C.A. 6662(b), 6664(c)(1); 26 C.F.R. 1.6662-3(b)(1, 3).
In determining whether a taxpayer's reliance on professional advice was reasonable, so as to avoid the imposition of an
accuracy-related penalty, courts evaluate any potential conflict of interest, the taxpayer's knowledge and expertise, and whether
the transaction seems too good to be true. 26 U.S.C.A. 6662(b), 6664(c)(1).
Bank knew that both principal marketer of STARS (Structured Trust Advantaged Repackaged Securities) transaction and
law firm that marketer recommended to bank had significant interest in convincing bank to engage in transaction, and bank
had ample capacity to recognize that transaction was too good to be true, and thus bank did not reasonably rely on advice
given by marketer or firm in its tax treatment of transaction and imposing accuracy-related penalty was warranted; bank knew
that marketer would not receive $6.5 million fee unless bank entered transaction, and thus that it had clear conflict of interest,
at time bank retained firm's services, it was aware that firm was transaction's co-developer and stood to profit considerably
from bank's adoption of transaction, and bank's executives were highly-educated and well-versed in banking transactions and
financing deals. 26 U.S.C.A. 6662(b)(1-2), 6664(c)(1); 26 C.F.R. 1.6662-3(b)(1, 3).
In the situation of a tax shelter, the defenses of adequate disclosure or substantial authority, standing alone, are insufficient
to avoid the imposition of penalties. 26 U.S.C.A. 6662(d)(2)(C)(i); 26 C.F.R. 1.6662-4(g)(1).
STARS (Structured Trust Advantaged Repackaged Securities) transaction's significant purpose was avoidance or evasion or
federal income tax, and thus it fell within statutory definition of tax shelter and was also economically meaningless transaction,
precluding any finding of substantial authority, as required for participating bank to avoid imposition of accuracy-related
penalty; transaction was no more than circular redirection of cash flows from United States Treasury to bank, its United Kingdom
(U.K.) trustee, and U.K. Treasury. 26 U.S.C.A. 6662(d)(2)(C)(iii); 26 C.F.R. 1.6662-4(g)(1).
220XXXI(C) Assessment
220k5232 Evidence
220k5233 k. Presumptions and burden of proof in general. Most Cited Cases
Taxpayer bears the burden of showing that reasonable cause and good faith exception to the imposition of an accuracy-related
penalty applies. 26 U.S.C.A. 6664(c)(1).
*126 Bank did not act with reasonable cause or in good faith in its tax treatment of STARS (Structured Trust Advantaged
Repackaged Securities) transaction, and thus bank could not avoid imposition of accuracy-related penalty on those grounds;
advice provided by transaction's principal marketer and law firm that marketer recommended to bank was based upon
unsupportable assumptions, both marketer and firm had significant conflicts of interest of which bank was aware, bank's
executives had high level of knowledge and expertise in banking transactions and financing deals, and evidence showed that
tax avoidance was singular goal pursued in execution of transaction. 26 U.S.C.A. 6662(b), 6664(c)(1).
Rajiv Madan, with whom were John B. Magee, Christopher P. Bowers, Christopher P. Murphy, Royce Tidwell, Nathan P.
Wacker, and Nicholas L. Wilkins, Bingham McCutchen LLP, Washington, D.C., and James C. McGrath and Deana K. El-
Mallawany, Bingham McCutchen LLP, Boston, Massachusetts, for Plaintiff.
Dennis M. Donohue, with whom were John L. Schoenecker, Raagnee Beri, Kari M. Larson, and William E. Farrior, Trial
Attorneys, and Alan S. Kline, Special Attorney, Tax Division, U.S. Department of Justice, Washington, D.C., for Defendant.
Tax Refund Suit; STARS Structured Transaction Between BB & T Bank and Barclays Bank; Availability of Foreign Tax
Credits From Payment of United Kingdom Taxes; Deductions for Interest and Transaction Costs; Economic Substance Doctrine
Applied to Trust and Loan Components of Transaction; Assessment of Penalties.
OPINION AND ORDER
WHEELER, Judge.
In this tax refund case, the Court must determine the proper tax treatment for an unusually complex financial transaction
known as STARS (Structured Trust Advantaged Repackaged Securities). Plaintiff, Salem Financial, Inc. (Salem), is a
subsidiary of BB & T Corporation, a bank chartered under the laws of North Carolina. Although many entities were involved
in the STARS transaction, the real parties in interest were BB & T Bank and Barclays Bank PLC, which is headquartered
in the United Kingdom (U.K.). The other entities were created or became involved to serve some special purpose for the
transaction. The BB & T STARS transaction was in effect for nearly five years, from August 1, 2002 through April 5, 2007.
The purpose of the STARS transaction was to generate *549 large-scale foreign tax credits for a U.S. taxpayer, which could
be used to enhance revenue and reduce taxes in the United States. The amount at issue in this case, including the potential
assessment of taxpayer penalties, is $772,144,153.45. This amount is comprised of the following: disallowed foreign tax credits
($498,161,951); disallowed interest deductions ($74,551,947.40); the tax paid on Bx payments from Barclays to BB & T
($84,033,228.20); disallowed transaction cost deductions ($2,630,125.05); and penalties ($112,766,901.80).
The complexities of the STARS transaction, including the concept of a Bx payment, will become apparent below. Stripped
to its essence, however, STARS called for the U.S. taxpayer, in this case BB & T, to establish a trust containing approximately
$6 billion in revenue-producing bank assets. The monthly revenue from the trust was then cycled through a U.K. trustee, an act
that served as a basis for U.K. taxation. Although the revenue was immediately returned to BB & T's trust, the assessment of
U.K. taxes generated U.K. tax credits that were shared 50/50 between Barclays and BB & T. A $1.5 billion loan from Barclays
to BB & T also was part of the structured transaction, although the loan was not necessary to the objective of generating foreign
tax credits. The Barclays monthly Bx payment to BB & T represented BB & T's share of the tax credits, and had the effect of
reducing the interest cost of BB & T's loan. The main question presented is whether the STARS transaction had any purpose
other than to generate tax savings, and if not, *127 whether penalties should be assessed against BB & T. [FN1]
The parties provided a STARS tax tutorial presentation to the Court on February 13, 2013 before the trial began. The Court
held 21 days of trial in Washington, D.C. from March 4 through April 2, 2013. During the trial, the Court heard the testimony of
26 witnesses, of which thirteen were experts. The Court admitted deposition excerpts for eleven additional witnesses, principally
from those persons who reside outside the United States or where the parties agreed that a deposition could substitute for
relatively brief testimony. The Court received in evidence approximately 1,250 exhibits during the trial. The parties submitted
post-trial findings of fact and memoranda of law on June 7, 2013, and post-trial reply briefs on July 3, 2013. The Court heard
closing arguments on July 30, 2013.
There are different ways of looking at the BB & T STARS transaction, and the Court has wrestled with the question of how
best to analyze its various components. The STARS trust component, where BB & T revenue momentarily is cycled through
a U.K. trustee to create U.K. taxes and foreign tax credits, and then is returned to BB & T, quite clearly is an abusive tax
avoidance scheme. The trust creates a series of instantaneous circular cash flows starting and ending with BB & T where no
economic activity has occurred abroad to justify the assessment of a U.K. tax. While inarguably sophisticated and creative, the
trust purely and simply is a sham transaction accomplishing nothing more than a redirection of cash flows that should have
gone to the U.S. Treasury, but instead are shared among BB & T, Barclays, and the U.K. Treasury. The Court finds that the
trust component of STARS lacks economic substance.
However, the Court must consider whether the existence of Barclays' $1.5 billion loan to BB & T at favorable interest rates
somehow provides the necessary economic substance to salvage the STARS transaction. In analyzing this question, the Court
notes that the loan interest rate actually is higher than normal for BB & T until the Barclays' rebate of U.K. taxes through
the Bx payment comes into play. The Barclays' Bx payment each month from the sham trust transaction creates the unusually
attractive interest rates. Without the Bx payments, the Court is persuaded that BB & T would not have entered into the STARS
transaction. The loan transaction thus is substantially influenced by the payments from the sham trust. The loan *550 lacks
economic reality where the interest rate is so low that for nearly the first three years of the transaction, Barclays, the lender,
makes Bx payments to BB & T, the borrower, exceeding by millions the interest payments due from BB & T to Barclays. An
arrangement where a lender makes payments to a borrower for the first three years of a loan surely would raise the eyebrows
of even an experienced financier.
Regardless of whether the Court views the trust and the loan separately or together as one integrated STARS transaction,
the Court concludes that the entire arrangement must be disregarded for lack of economic substance. Among the most telling
evidence at trial was the revelation that the amount of the loan was unrelated to the amount of the Bx payments. That is, in the
relevant formulas created for the STARS transaction, a change in the loan amount does not have any effect on the Bx payment
amount. Thus, rather than being intricately linked together with the trust, the loan serves only to add a hoped-for business
purpose to the tax avoidance scheme. The Court cannot find economic substance in a loan transaction that is so *128 heavily
driven by Bx payments from the sham trust.
For reasons that will be explained, the Court also finds that BB & T is liable for tax penalties for its participation in the
STARS transaction. The conduct of those persons from BB & T, Barclays, KPMG, and the Sidley Austin law firm who were
involved in this and other transactions was nothing short of reprehensible. Perhaps the business environment at the time was
everyone else is doing it, why don't we? Perhaps some of those who participated simply were following direction from others.
Nevertheless, the professionals involved should have known better than to follow the STARS path, rife with its conflicts of
interest, questionable pro forma legal and accounting opinions, and a taxpayer with a seemingly insatiable appetite for tax
avoidance. One of Defendant's experts, Dr. Michael Cragg, aptly stated that enormous ingenuity was focused on reducing U.S.
tax revenues. Cragg, Tr. 4687. After wading through the intricacies of the STARS transaction, the Court shares Dr. Cragg's
view that [t]he human effort, the amount of creativity and overall effort that was put into this transaction ... is a waste of
human potential. Id.
I. Findings of Fact [FN2]
A. Entities Involved in the BB & T STARS Transaction
There are five business entities that each played an important role in this STARS transaction: (1) BB & T, which established
controlled subsidiaries to achieve certain transaction-related objectives; (2) Barclays PLC, which developed the concept of
STARS and served as a counterparty in the STARS structure; (3) KPMG LLP, an international accounting firm that assisted
Barclays in marketing STARS in the United States, and provided tax opinions to BB & T and other U.S. banks who chose to
participate; (4) Sidley Austin Brown & Wood LLP, a law firm which supplied tax opinions and legal services in connection
with STARS; and (5) PricewaterhouseCoopers LLP (PwC), an international accounting firm that served as BB & T's outside
auditing firm beginning in 2002 and examined the STARS transaction at BB & T's request. The Court will briefly describe
the role of each of these entities below.
1. BB & T
Branch Banking & Trust Corporation (BB & T) is a financial holding company headquartered in Winston-Salem, North
Carolina and incorporated in the State of North Carolina. Stip. 1. BB & T conducted business primarily through its banking
subsidiaries, which during 2002 through 2007 included offices in North Carolina, South Carolina, Virginia, Maryland, Georgia,
West Virginia, Tennessee, Kentucky, Alabama, Florida, and Washington, D.C. JX 209 at 358414. The largest subsidiary of
BB & T is Branch Banking and Trust Company (BB & *551 T Bank), a state bank chartered under North Carolina law.
Stip. 3; JX 209 at 358414. BB & T is the oldest bank headquartered in North Carolina, having been chartered in 1872. BB
& T Corporation has two other banking subsidiaries: (1) Branch Banking and Trust Company of South Carolina (BB & T-
SC), headquartered in Greenville, South Carolina; and (2) Branch Banking and Trust Company of Virginia (BB & T-VA),
headquartered in Richmond, Virginia. JX 209 at 358414.
As of December 31, 2002, BB & T Bank operated 335 branches, and was the second largest bank in North Carolina measured
by deposit market share. Id. at 358415. BB & T-SC operated 94 branches and was the third largest bank in South Carolina
measured by *129 deposit market share. Id. BB & T-VA operated 241 branches, and was the fourth largest bank in Virginia
measured by deposit market share. Id. BB & T Bank's principal subsidiaries include: BB & T Leasing Corp., based in Charlotte,
North Carolina, which provides lease financing to commercial businesses; BB & T Investment Services, Inc., also located in
Charlotte, which offers non-deposit investment services including annuities, mutual funds and discount brokerage services; BB
& T Insurance Services, Inc., headquartered in Raleigh, North Carolina, a retail insurance broker offering property and casualty,
life and other insurance products through 71 agencies in eight states; and Stanley, Hunt, DuPree & Rhine, Inc., headquartered
in Greensboro, North Carolina and Greenville, South Carolina, which offers group medical plans, insurance and investment
consulting, and actuarial services. Id.
From 1987 to 2002, BB & T acquired 56 community banks and thrifts, 60 insurance agencies, and 21 non-bank financial
services providers. Id. at 358418. During 1995, BB & T merged with Southern National Corporation, and retained the BB & T
corporate name for the merged entity. The transaction was described as a merger of equals because each entity had assets of
approximately $10 billion immediately prior to the merger. Through this combination, the assets of the merged entity doubled.
Johnson, Tr. 59; Goodrich, Tr. 383-84.
As a financial holding company, BB & T is subject to regulation under the Bank Holding Company Act of 1956, as amended,
and the examination and reporting requirements of the Board of Governors of the Federal Reserve Board. JX 209 at 358427.
As state-chartered commercial banks, BB & T Bank, BB & T-SC and BB & T-VA are subject to regulation, supervision,
and examination by state bank regulatory authorities in their respective home states. Stip. 3, 33. These authorities are the
North Carolina Commissioner of Banks, the South Carolina Commissioner of Banking, and the Virginia State Corporation
Commission's Bureau of Financial Institutions, respectively. Each of the state chartered banks also is subject to regulation,
supervision, and examination by the Federal Deposit Insurance Corporation. JX 209 at 358427.
The following present or former BB & T officers and employees testified at trial: (1) John Allison, former Chief Executive
Officer of BB & T Corporation; (2) John Watson, former Tax Director of BB & T Bank; (3) Donna Goodrich, former
Deposits and Corporate Funding Manager of BB & T and current senior executive vice president and member of the executive
management team; (4) Hal Johnson, former Corporate Finance Manager of BB & T; (5) Ronald Monger, former overseer of
the BB & T Bank Tax Department and Manager of Shareholder Reporting; (6) Howard Hudson, in-house counsel at BB & T;
(7) Ida Marie Hyder, Balance Sheet Risk Manager for BB & T; and (8) Katherine Coffield, accounting employee responsible
for day-to-day operations relating to the STARS transaction.
2. Barclays
Barclays Capital is the investment banking division of Barclays Bank PLC. Abrahams Dep., 534-35. The Structured Capital
Markets Group of Barclays Capital developed the STARS-type of structured transaction. The Structured Capital Markets Group
(SCM) generally was responsible for executing complex structured transactions. Id. at 16, 535. SCM's objectives were to
identify and create value enhancements through accounting, legal,*552 regulatory and tax opportunities, which in some cases
involved exploiting differences between tax systems in different countries. Sultan, Dep. 10, 533.
Barclays Capital's structured finance transactions required approval from the SCM Approvals Committee, and were subject to
review by two separate credit committees based upon the dollar amount involved. Sultan, Dep. 135-36, 147-48; Abrahams, Dep.
19-20; PX 297 at 204218R. Barclays Capital operated *130 the Barclays Capital Credit Committee (BCCC) and Barclays
Group (consisting of Barclays entities and business units worldwide) operated its own Group Credit Committee (GCC),
which had ultimate credit authority for Barclays transactions. Abrahams, Dep. 579. When a transaction exceeded a fixed size,
it had to be submitted to the BCCC following approval by the SCM Approvals Committee. Sultan, Dep. 147-48. For still larger
transactions, BCCC and GCC approvals were required. Sultan, Dep. 150-51, 158-59; Abrahams, Dep. 21. For complex or
structured transactions, any submission to the GCC had to include an explanation of the transaction structure. Abrahams, Dep.
92. The BB & T STARS transaction required GCC approval and an extensive review. Id. 601-02.
Each year, Barclays Group engaged in a budgeting process under which the Group's total regulatory capital was allocated
among its various business divisions, including Barclays Capital. Id. 32. Barclays Capital in turn allocated regulatory capital
among its various business units, including SCM. Id. Each business division was assigned a revenue target and charged with
the duty of managing its transactions and consumption of regulatory capital to produce an acceptable overall return. Id. 556.
Barclays recently disbanded SCM amid reports that it was a tax avoidance unit. Peacock, Tr. 2270-71. Former U.K. Chancellor
of the Exchequer Nigel Lawson called SCM's business industrial scale tax avoidance. Monger, Tr. 1220-23.
The following Barclays personnel provided deposition testimony that the Court admitted into evidence: [FN3] (1) Iain
Abrahams, an employee of the Barclays SCM division responsible for managing risk of the structured transactions; (2) Sohail
Sultan, a Barclays SCM division employee involved in the initial conceptualization of STARS and its development into a
viable structure that could be promoted to North American banks as a tax-advantaged financial product; (3) Alkis Ioannidis, a
Barclays SCM division employee who worked with Mr. Sultan on structured investments and finance; and (4) David Williams,
a Barclays Group Tax Department employee, responsible for overseeing the compliance of Barclays Group with U.K. tax laws.
3. KPMG
KPMG is an international accounting firm, providing accounting and tax services to its clients around the world. Beginning
in 1999, KPMG partnered with Barclays to promote the STARS structure in the United States, and to explain the mechanics
of STARS and its tax benefits to U.S. banks who might be interested in participating. Sultan Dep. 691-92; USX 69, 335.
Washington National Tax (WNT) is an office of KPMG tax professionals in the United States who are organized based upon
practice specialty such as corporate tax, partnership tax, and international tax, among others. Wilkerson, Tr. 1636. In 2002, the
international tax group in WNT consisted of 30-35 tax professionals. Id. 1640-41. KPMG introduced the STARS transaction to
BB & T at a January 17, 2002 meeting, using a slide show presentation to outline the various steps. Monger, Tr. 970; Watson,
Tr. 3425; USX 343. Except for some limited audit work that KPMG performed on a BB & T mutual fund, BB & T was not
a client of KPMG during 2002-2007. Monger, Tr. 1150.
Robert Wilkerson was the only KPMG witness who testified at trial. Mr. Wilkerson was a principal in the international
tax group of the WNT office. David Brockway, the partner in charge of the WNT office, was *553 heavily involved in the
development of the STARS concept, and in drafting STARS tax opinions and promotion materials. At the time of trial, Mr.
Brockway worked for Plaintiff's law firm, Bingham McCutchen LLP, Wilkerson, Tr. 1865, but he did not testify.
*131 4. Sidley Austin Brown & Wood
Sidley & Austin LLP was an international law firm that merged with Brown & Wood in 2001 to become Sidley Austin
Brown & Wood LLP. Chapman Tr. 2976, 3177. At all relevant times before the merger, these two firms each maintained a
tax department. Id. 2982. Raymond J. Ruble was a partner in Brown & Wood's tax department, and then with Sidley Austin
after the merger. USX 85. By 2000, Mr. Ruble had built a significant tax practice based upon developing and promoting tax
shelters, which he called structured tax products. Id. He coordinated much of his work with KPMG, Ernst & Young, Arthur
Andersen, and BDO Seidman. Id. Mr. Ruble also developed a relationship with Mr. Sultan of Barclays, with whom he worked
to create and promote the STARS transaction. Sultan, Dep. 38, 532. At the suggestion of Barclays and KPMG, BB & T hired
Sidley Austin, and specifically Mr. Ruble, to provide a tax opinion for the BB & T STARS transaction. Hudson, Tr. 1518-19,
1545-47; Chapman, Tr. 3062-63; JX 264; USX 436, 617. Mr. Ruble signed the May 7, 2002 engagement letter where BB &
T retained Sidley Austin as legal counsel. JX 264. BB & T had not previously used Sidley Austin as its counsel. Hudson, Tr.
1549. BB & T received two Sidley Austin opinions for STARS. The first was a U.S. tax opinion authored by Mr. Ruble. Id. at
1518-19. The second was a U.K. tax opinion. Monger, Tr. 1301-02, 1347-48; JX 287.
Craig Chapman was the only Sidley Austin witness at trial, although the Court accepted the deposition of Graeme Harrower
into evidence as an unavailable witness who resides in the U.K. Mr. Chapman is a partner in Sidley Austin's New York office
and is co-head of the global securities practice. Chapman, Tr. 2974-76. He advised BB & T on the STARS transaction alongside
Mr. Ruble, as well as advising Bank of New York and Sovereign Bank on their respective STARS transactions. Id. at 2974.
Mr. Chapman, however, is not a tax lawyer. Id. at 3048.
Mr. Chapman's work on BB & T's STARS transaction began when Barclays contacted Sidley Austin to ask if the law firm
would represent BB & T on the transaction. Chapman, Tr. 3008. Shortly thereafter, Mr. Ruble and Mr. Chapman traveled to
Winston-Salem, North Carolina to meet with BB & T's Ronnie Monger, John Watson, and Howard Hudson to discuss STARS.
Chapman, Tr. 3008-10. BB & T then retained Sidley Austin as its counsel for STARS. Id. at 3010. Mr. Chapman testified that
he was the relationship partner with BB & T, but Mr. Ruble signed the engagement letter with BB & T. Id.; JX 264 at 902.
Sidley Austin issued Mr. Ruble's tax opinion letter on STARS to BB & T on April 4, 2003. Stip. 74; PX 174. In October
2003, Sidley Austin expelled Mr. Ruble from the law firm due to serious irregularities in his tax shelter practice. Harrower,
Dep. 253-54. BB & T became aware that Mr. Ruble had been terminated from Sidley Austin. Hudson, Tr. 1598; Watson, Tr.
3553-54. In November 2003, in hearings before the U.S. Senate's Permanent Subcommittee on Governmental Affairs, and with
respect to the Subcommittee's investigation of U.S. Tax Shelter Industry: the Role of Accountants, Lawyers, and Financial
Professionals, Mr. Ruble refused to respond to questions, citing his Fifth Amendment right not to answer. USX 1526 at 100-01;
Wilkerson, Tr. 1849-50.
In August 2005, the United States indicted Mr. Ruble and charged him with tax evasion for designing, implementing, and
marketing fraudulent tax shelters. United States v. Pfaff, 619 F.3d 172, 173 (2d Cir.2010). On December 17, 2008, a jury
found Mr. Ruble guilty on ten counts of attempting to evade or defeat U.S. tax laws, and he was sentenced to 78 months of
incarceration and two years of supervised release. He currently is incarcerated in the United States penitentiary in Lewisburg,
Pennsylvania. Defendant deposed Mr. Ruble in this case, but in response to every question after providing his name, Mr. Ruble
asserted his Fifth Amendment right not to answer. *132 Mr. Ruble did not testify at trial. The STARS transactions *554 were
not among the tax shelters at issue in Mr. Ruble's criminal proceedings.
Prior to the start of trial, Plaintiff filed a motion in limine to preclude Defendant from seeking adverse inferences against
Plaintiff due to Mr. Ruble's assertion of the Fifth Amendment in response to all questions. Later, after trial, Plaintiff filed a
motion to reopen the trial record to obtain Mr. Ruble's substantive testimony in response to written questions previously posed
to him in his deposition. On June 13, 2013, the Court issued an order regarding the testimony of Raymond J. Ruble, denying
Plaintiff's motion to reopen the trial record, but granting Plaintiff's motion to preclude the application of an adverse inference
from Mr. Ruble's assertion of his Fifth Amendment rights. The Court reasoned that Mr. Ruble most likely had asserted the
Fifth Amendment for personal reasons, not because of a desire to protect Plaintiff or influence the outcome of this case. See
Order, June 13, 2013, D kt. No. 213.
5. PwC
In March 2002, after terminating Arthur Andersen & Company as its audit firm, BB & T selected the PwC accounting firm
to be its new outside auditor. Monger, Tr. 774-75, 1151-53; USX 470. One of PwC's first tasks was to evaluate the STARS
transaction, with a specific focus on the STARS tax reserve level. Monger, Tr. 776-77, 1161, 1190. BB & T did not seek a
separate legal opinion from PwC regarding the STARS transaction. Monger, Tr. 945-47; JX 259 at 277. Ultimately, PwC arrived
at a less than should level of comfort that the Internal Revenue Service (IRS) would accept the STARS transaction, but
BB & T nonetheless decided to move ahead with the transaction. Boss, Tr. 2098, 2100-02, 2117-18; USX 951 A at 7183-84;
JX 256 at 2802; USX 553, 601, 611.
PwC expressed concerns that the STARS transaction did not comply with technical provisions of the Internal Revenue Code.
Monger, Tr. 782-85; PX 42; JX 259 at 278-85; USX 529. After PwC had articulated these concerns, Mr. Monger told PwC on
April 19, 2002 to focus strictly on the STARS tax reserve issue. Monger, Tr. 1257-58; JX 259 at 277. If the reserve level was
too high, STARS would not be profitable to BB & T even on an after-tax basis, and BB & T would not go forward with the
transaction. Monger, Tr. 776-77, 1239-43, 1246.
PwC representatives Rich Boss and Chip Harter testified at trial. Mr. Boss was an international tax manager in PwC's Charlotte
office, and took the lead in coordinating PwC's national tax group and the audit team. Mr. Harter was an international tax
specialist in PwC's Washington, D.C. office, and provided technical assistance on certain STARS issues.
B. BB & T's Participation in Other Tax Shelters
Aside from the STARS transaction, BB & T has had a number of experiences with other transactions designed to reduce
U.S. tax liabilities, some of which ultimately were disallowed for tax purposes. These transactions include lease-in-lease-out
(LILO) and sale-in-lease-out (SILO) tax shelters, employed during 1997 through 2001, a structured transaction known as
OTHELLO, which KPMG marketed to BB & T in 2002, and Project Knight in 2007, another Barclays structured transaction
similar to STARS.
1. SILO/LILO
In 1997 through 2001, BB & T entered into many LILO transactions that were later disallowed for tax purposes. PX 68 at
382688. In these transactions, BB & T acquired leasehold interests in two convention centers and various equipment, and entered
into operating leases with foreign municipal corporations and entities. Id. BB & T entered into similar SILO transactions that
also were disallowed. Monger, Tr. 1269-70; PX 68 at 382688. A key objective of SILOs and LILOs was for the taxpayer to take
advantage of depreciation deductions on assets owned by public entities, without assuming any of the ownership risks *133
of these assets. See, e.g., Wells Fargo & Co. v. United States, 91 Fed.Cl. 35 (2010) (denying tax deductions for public transit
industry equipment where tax shelter transactions lacked economic substance), aff'd, 641 F.3d 1319 (Fed. Cir.2011). These
SILO and LILO tax shelters involved *555 circular cash flows aimed at reducing taxes, just as the STARS transaction does.
In a February 2002 presentation to BB & T's Board of Directors, the Tax Management team described the benefits of these
tax shelters as including deferred income taxes of $635 million through December 31, 2001, and an additional $12.1 million
in 2001 earnings. PX 29 at 361386; Monger, Tr. 1046-47. BB & T entered into approximately 37 SILO or LILO transactions
between June 1997 and July 2001. Watson, Tr. 3515-16; PX 68 at 382688-89. The cumulative tax loss on the SILO/LILO
transactions for 1997 through 2001 was $1.4 billion. The projected losses for 2002, 2003, and 2004 were $343 million, $122
million, and $65 million respectively. PX 68 at 382687; Watson, Tr. 3516.
As of February 2002, the IRS had completed its audit of BB & T's 1996 through 1998 taxable years, and had determined that
the SILO/LILO deductions claimed for those years would be disallowed. Monger, Tr. 1047-48; PX 92 at 350335. BB & T was
aware that the IRS would be disallowing hundreds of millions of anticipated tax benefits from the ongoing SILO and LILO
transactions. Watson, Tr. 2886-87; Monger, Tr. 1049-50; PX 29 at 361392.
BB & T filed a tax refund action in the U.S. District Court for the Middle District of North Carolina challenging the IRS's
disallowance of the tax benefits claimed on one of its LILO transactions. On January 4, 2007, the district court granted summary
judgment in favor of the United States. BB & T Corp. v. United States, 2007 WL 37798, 2007 U.S. Dist. LEXIS 321 (M.D.N.C.,
Jan. 4, 2007). On appeal, the U.S. Court of Appeals for the Fourth Circuit affirmed the district court's grant of summary
judgment. BB & T Corp. v. United States, 523 F.3d 461 (4th Cir.2008). BB & T's management quickly understood the adverse
impact that these court decisions would have on BB & T's continued participation in LILO and SILO transactions. Watson, Tr.
3588-89. BB & T settled its other LILO and SILO disputes after receiving the Fourth Circuit's decision. Watson, Tr. 3517-18.
2. OTHELLO
In January 2001, before the beginning of the STARS transaction, BB & T began implementing another tax shelter promoted by
KPMG called OTHELLO, which reduced BB & T's effective tax rate. Watson, Tr. 3510, 3530; Monger, Tr. 966; USX 941. BB
& T paid KPMG $4.5 million in fees for carrying out the OTHELLO transaction. Monger, Tr. 1178; USX 483 at 3. These fees,
however, were linked to the favorable tax consequences that BB & T anticipated from OTHELLO. A portion of KPMG's fees
was deferred until the tax year when OTHELLO closed, or until the IRS examined the transaction. Monger, Tr. 1181-83; USX
485. Deferring these fees ensured that KPMG would not be fully compensated until OTHELLO's tax risk had been determined.
Id. BB & T considered a similar risk-sharing arrangement with KPMG on the STARS transaction, deferring a portion of KPMG's
fees until a later period. Monger, Tr. 1177-79; USX 485. The OTHELLO and STARS transactions had similar characteristics.
Wilkerson, Tr. 1845-46; Monger, Tr. 1307; USX 950 at 3; USX 634. The November 2003 Senate Hearings on tax shelters
characterized OTHELLO as a potentially abusive tax shelter. USX 1526 at 193, 228.
3. Project Knight
Near the termination of STARS, BB & T entered into another tax shelter with Barclays known as Project Knight. Johnson,
Tr. 253-54; PX 260 at 259802. In January 2007, BB & T anticipated that Project Knight would involve receiving a $4 billion
loan from Barclays for three years at a floating interest rate of LIBOR [FN4] minus 40 basis points. USX 1944 at 2. BB & T
believed that Project Knight would produce a $12 *134 million tax benefit each year. Id.
Project Knight had many features very similar to STARS. Johnson, Tr. 255-56. Like STARS, Project Knight involved
setting up an entity structured as a joint investment between BB & T and Barclays. Id. While the joint investment in STARS was
a trust, *556 in Project Knight it was a partnership. Id. Just as in STARS, Project Knight involved placing assets in the structure
to generate income--the same auto loan assets used in STARS. Johnson, Tr. 255, 352. Project Knight involved a forward sale
agreement for undoing ownership interests at the end of the transaction. Johnson, Tr. 255. Project Knight incorporated a swap
instrument designed to turn a fixed-rate interest rate obligation into a floating interest obligation. Id. Project Knight involved a
purported sub-LIBOR loan from Barclays to BB & T, which has been characterized as a sharing of Barclays' U.K. tax benefits.
Johnson, Tr. 258; USX 1944 at 2. BB & T and Barclays could unilaterally terminate Project Knight early for any reason.
Johnson, Tr. 324.
The termination provisions in Project Knight were important to the parties. BB & T contemplated that the IRS might challenge
Project Knight, and it planned to terminate the transaction if this occurred. USX 1944 at 3. BB & T also expected that Barclays
would terminate Project Knight early if it did not receive its planned tax benefits, and BB & T would do the same if its tax
benefits were not forthcoming. Johnson, Tr. 286-88; USX 1944 at 3.
BB & T and Barclays terminated Project Knight in 2008. Watson, Tr. 2876. Barclays had come under mounting media
attention regarding its role in U.S. banks' participation in foreign tax shelters. On March 29, 2009, the U.K. newspaper The
Guardian reported U.S. banks pull out with 11 billion Barclays tax avoidance partnerships: Bank of America and BB & T
repay loans early, Project Knight meant to generate 100 million next year. Johnson, Tr. 332-36. The Guardian also referred to
Barclays' Structured Capital Markets unit as a tax avoidance factory and reported that in 2009, whistleblowers uncovered
SCM's dark arts practice that created multibillion pound deals, which routed vast amounts of money in elaborate circles
through offshore networks with the prime purpose of magic-ing profits out of tax credits. Peacock, Tr. 2270-71; Monger, Tr.
1220-23. As noted above, Barclays disbanded its SCM unit in the wake of negative publicity.
C. Design and Development of STARS
BB & T's STARS transaction does not stand in isolation. Barclays and KPMG principally developed the concept of STARS
over a long-term period to achieve tax benefits. Barclays and KPMG marketed STARS to bank and non-bank businesses in the
United States, and ultimately executed STARS transactions with six U.S. banks, including BB & T. The evolution of the STARS
structure, and the near identical method of implementation with the six U.S. banks, sheds light on the purpose of STARS and
its dependence on a series of tax-motivated steps.
1. Developers
Sohail Sultan of Barclays' SCM division led the development of STARS. Sultan, Dep. 73. Mr. Sultan also marketed other
SCM products to U.S. financial institutions and remained engaged in the execution of STARS deals as a transaction team leader.
Id. Originally, STARS was a strategy to enhance the investment yield of large, cash-rich corporations in the United States,
Canada, and Europe. Id. at 25. Mr. Sultan marketed the early iteration of STARS to Microsoft, AIG, Intel, and Prudential.
Id. 187-88. In general, these entities responded that the yield enhancement was not attractive enough to justify the level of
complexity and potential risks. Id. With this *135 feedback, Barclays decided to retain the structural components from the
early iterations of STARS and combine them with a financing vehicle that might be attractive to banks. Id. at 60-62.
The London law firm of Freshfields, Bruckhaus, Deringer LLP assisted Mr. Sultan with the development of the STARS
structure. Mark Watterson of Freshfields analyzed the U.K. tax treatment of STARS and provided advice to Barclays on the tax
effects of including the unit trust and the U.K. trustee, both of which were central components of STARS. Watterson, Dep. 18,
29-33. Mr. Watterson conveyed his views of U.K. tax treatment to KPMG's Mr. Brockway for use in determining how STARS
might be characterized from a U.S. tax perspective. Id. at 123-24.
During the period when Barclays developed STARS, Barclays had an agreement *557 with the U.K. taxing authority, Her
Majesty's Revenue & Customs (HMRC), under which all newly-closed SCM transactions would be submitted for review at
the end of the year to determine whether they would be challenged under U.K. tax law. Williams, Dep. 114-17. This process
allowed Barclays' Tax Group to explain the complex structures and draw HMRC's attention to potential nuances that might
not otherwise be apparent. Id. at 121-22.
In 2001 and 2002, John Mawson served as the U.K. Principal Inspector of Taxes responsible for reviewing the tax affairs of
the Barclays Group. Id. at 116-17. Starting in August 2001, Messrs. Williams and Mawson engaged in discussions regarding the
first STARS deal, the First Union Bank transaction referred to as Monument Street Funding. Id. at 113-14; USX 358. In a letter
dated April 16, 2002, Mr. Williams stated [i]n respect of both First Union and Bank of New York transactions this leads to
additional U.K. corporate tax payable by the Barclays Group as a result of the transaction of 5.7m in 2001 and approximately
30.2m in 2002 (please see schedule at Point 4 below.) USX 557 at 2-4; Zailer Tr. 2696-97. Mr. Watterson of Freshfields
observed if the U.K. Revenue could see that these transactions [STARS] were tax additive to the Revenue or to the Exchequer
then they'd probably be less minded to seek to challenge the result that Barclays was looking to achieve. Watterson, Dep.
107-08. In reality, however, Barclays did not pay any U.K. corporate tax on either of these STARS transactions. Zailer, Tr. 2697.
The amounts listed in Mr. Williams' April 16, 2002 letter actually were paid by First Union and the Bank of New York, through
the trustees of their Delaware trusts. Id. at 2698, 2702. This letter makes it appear that Barclays is paying a U.K. corporate tax,
but in fact Barclays was receiving tax benefits while paying no U.K. tax at all. Zailer, Tr. 2700-05; Demo. Ex. 12-13; USX 557.
Through collaboration with Barclays, KPMG specialized in developing transactions that took advantage of differences
between tax systems, including STARS. Wilkerson, Tr. 1779-80. The initial STARS development focus was on achieving tax
objectives, including U.K. tax objectives. Id. at 1757. For the U.S. participants, the primary objective was to claim foreign
tax credits, while characterizing the transaction as a financing. Id. 1757, 1774. Without the foreign tax credits, the STARS
transaction would not be profitable to the U.S. taxpayer. Id. at 1760-61. In order to characterize STARS as involving a loan,
KPMG wanted to avoid negative interest and to assure that the U.S. participant receiving the loan would make at least some
positive interest payments. Id. at 1759. However, in the BB & T STARS deal, the first 35 months of the transaction involved
payments from Barclays (as lender) to BB & T (as borrower), and no payments going the other way. Wilkerson, Tr. 1759;
Kawaller, Tr. 4901-02; Demo. Ex. 18; USX 1994 at 22.
Mr. Brockway of KPMG performed extensive development work on STARS to enable Barclays and KPMG to market the
transaction. USX 192 at 3. In the first half of 2000, nearly all of KPMG's time devoted to STARS consisted of Mr. Brockway's
services. Id. *136 Mr. Wilkerson joined Mr. Brockway in analyzing technical tax issues relating to the First Union transaction,
including the important question of whether First Union would be allowed to claim foreign tax credits under Internal Revenue
Code (IRC) 901. Wilkerson, Tr. 1679-80. Mr. Wilkerson also analyzed the possible use of deconsolidation to assure that
First Union could fully utilize the foreign tax credits, an issue that also arose in the BB & T STARS transaction. Id. at 1760.
In developing STARS, KPMG treated Barclays as its client. Wilkerson, Tr. 1755-56; Sultan Dep. 655; USX 957 at 1-3. Under
a revised fee arrangement, KPMG's accrued time was folded into the value based fee, and thus made contingent on the closing
of a STARS transaction. USX 192 at 3. KPMG understood that Barclays would pay a larger fee on STARS transactions where
KPMG had identified the client or played an important role in Barclays landing the engagement. USX 108 at 2. KPMG initially
expected a $1 million fee from Barclays if the first STARS transaction (First Union) successfully*558 closed. Wilkerson, Tr.
1763; USX 108 at 1. Instead, Barclays paid KPMG $4 million for the First Union STARS deal, and more fees were promised
if other STARS transactions could be closed. Wilkerson, Tr. 1763-65; USX 108 at 2.
In light of the fee structure, KPMG encouraged its professionals to promote STARS and provided incentives for them to do
so. Wilkerson, Tr. 1776; USX 342. Mr. Wilkerson personally met with prospects, including SunTrust Bank, Regions Bank,
and Key Bank to present STARS and explain its U.S. tax benefits. Wilkerson, Tr. 1769-71. Mr. Wilkerson conveyed his view
that the transaction would achieve its intended U.S. tax objectives by generating foreign tax credits in the United States while
allowing the structure to be characterized as a financing. Id. 1773-74. KPMG hoped that it could realize more fees through the
execution of additional STARS transactions. Id. at 1772. The relationship between Barclays and KPMG was so close that Mr.
Brockway even asked for input from Mr. Sultan on setting compensation levels for KPMG professionals working on STARS.
Wilkerson, Tr. 1792; USX 957 at 3. Mr. Sultan suggested compensation of approximately $1 million for each of the KPMG
persons with whom Barclays worked. USX 957 at 2.
2. Early Iterations of STARS
STARS was not always characterized as low cost financing. Sultan, Dep. 188; PX 312 at 224352R. In 1999, STARS
conceptually began as an investment-based transaction or an asset play involving a U.K. unit trust that would generate an
enhanced return for a U.S. investor by way of a Stock Lending Arrangement (SLA). Sultan, Dep. 188; USX 69 at 1. The
transaction would enhance[ ] the yield on an existing portfolio of assets held by a U.S. counterparty, generated by allowing
Barclays to claim the taxes paid on the income accrued on the portfolio of underlying assets through a U.K. unauthorised trust.
PX 312 at 224352R. The enhanced yield would be accomplished through a stock loan from the U.S. participant to Barclays
with the U.S. participant receiving lending fees that represented a split of the tax benefits. Id.
This asset play investment version of STARS did not have a loan component going from Barclays to the U.S. participant.
Abrahams, Dep. 263-64; USX 89. However, a STARS transaction did not need a loan component to accomplish its tax
objectives. Abrahams, Dep. 742. From Barclays' standpoint, a STARS deal only needed a U.S. counterparty to help Barclays
create a purported trading loss that formed part of the transaction's U.K. benefit for Barclays. Id. at 742-44, 859-62. Without
a counterparty to create the appearance of some financial activity, Barclays may not have been able to deduct the purported
loss for U.K. tax purposes. Id.
Barclays marketed the investment version of STARS to well-known corporations, AIG, Microsoft, Intel, and Prudential.
Sultan, Dep. 188. Barclays targeted *137 these entities because they were viewed as having excess assets that could be used
to move revenue through the transaction structure. Id. This version of STARS had no loan component. Mr. Sultan found, for
example, that Microsoft was not plausibly interested in a $1.5 billion loan. Id. at 188-89. By lending to a corporation such
as Microsoft, Barclays would need to maintain 100 percent of its regulatory capital requirements associated with such a loan,
as opposed to a fractional amount for bank lending. Id. at 189-91. Ultimately, none of the targeted U.S. companies chose to
participate. Id. at 194; James, Tr. 3832. STARS therefore had to evolve by adding a loan component to the transaction, which
Barclays was able to sell to six banks.
Barclays would have preferred to execute STARS without a loan to the U.S. participant, because the loan feature required
Barclays to commit capital to the transaction. Id. at 209-10. By adding a cash loan, Barclays was required to retain more
regulatory capital. Id. at 209-211. However, the economic benefit to the U.S. participant arising from its foreign tax credits
remained the same for both the investment version and the later loan version of STARS. Sultan, Dep. 349-50; USX 102.
3. Prior STARS Transactions With First Union and Bank of New York
Barclays entered into six STARS transactions with U.S. financial institutions between *559 2001 and 2005: First Union
National Bank in June 2001, Bank of New York in November 2001, BB & T in August 2002, Wells Fargo in November 2002,
Sovereign Bank in November 2003, and Washington Mutual in June 2005. PX 297 at 204207R; JX 2; USX 1502; USX 2095;
USX 2210 at 41, n.97; USX 2212 at 121. Two of these transactions, First Union and Bank of New York, closed before the BB
& T STARS transaction. Barclays itself has described First Union as very similar to BB & T STARS. PX 297 at 204207R.
The First Union STARS transaction involved financing in the amount of $2.5 billion and a commitment of approximately
$7 billion in First Union assets to the STARS trust structure. Ioannidis, Dep. 150; Sultan, Dep. 193; USX 358 at 2; USX 1389.
The First Union STARS transaction currently is in litigation. As successor in interest to First Union through its merger with
Wachovia in 2001 and through its acquisition of the merged entity, Wells Fargo filed suit on August 13, 2012 challenging the
IRS tax treatment of the First Union STARS transaction. The litigation is ongoing. Monument St. Funding Trust, Centurion
Funding, Inc., Tax Matters Partner v. Comm'r, Dkt. No. 20216-12 (U.S. Tax Court, 2012).
Bank of New York (BNY) was the second U.S. financial institution to implement a STARS transaction with Barclays,
on November 9, 2001. Chapman, Tr. 3008. At that time, BNY was engaged in the banking business and had worldwide
banking operations. Bank of New York Mellon Corp. v. Comm'r, 140 T.C. 15, 17 (2013). KPMG introduced STARS to
BNY during discussions with the bank's tax director. Id. Thereafter, KPMG and Barclays presented STARS to BNY through
various meetings, discussions, promotional materials and correspondence. Id. Barclays described BNY STARS as substantially
similar and very similar to BB & T STARS. PX 297 at 20407R, 204214R. The transaction involved a $1.5 billion financing
and a commitment of more than $7.8 billion in BNY assets to the STARS trust structure. Bank of New York, 140 T.C. at 20-21.
The IRS challenged BNY STARS, and the matter was tried in the U.S. Tax Court in April 2012. The Tax Court issued an
opinion on February 11, 2013, finding in favor of the Government. The Tax Court concluded:
In sum, the STARS transaction (bifurcated or integrated) lacks economic substance and Congress did not otherwise intend
to provide foreign tax credits for transactions such as STARS. Accordingly, the STARS transaction is invalid for Federal tax
purposes *138 and the foreign tax credits and expense deductions claimed in connection with it are disallowed.
Id. at 48. The Tax Court emphasized:
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.
Id. at 31. In addition, the Tax Court found that the activities or transactions that the STARS structure was used to engage in
did not provide a reasonable opportunity for economic profit. The STARS structure's main activity was to circulate income to
itself and Barclays.... These circular cash flows or offsetting payments had no non-tax economic effect. Id. at 35-36.
D. Marketing of STARS to BB & T
1. Initial Contact with KPMG
In November 2001, Mr. Monger received a telephone call from Maurice Beshlian of Barclays, in which Mr. Beshlian asked
Mr. Monger to put him in contact with BB & T's corporate tax director regarding tax implications of the STARS transaction.
Monger, Tr. 958-63. Thereafter, on November 20, 2001, Messrs. Beshlian and Sultan of Barclays participated in a telephone
call with Mr. Watson, the head of BB & T's Tax Department, in which they discussed in some detail [BB & T's] appetite to
do a [foreign tax credit] trade. USX 308. In the follow-up correspondence, they agreed to meet in January 2002 to discuss the
STARS *560 transaction and the tax issues involved. Id.; Monger, Tr. 625, 632.
On January 17, 2002, Mr. Monger and Mr. Watson met with three tax specialists from KPMG--David Brawley, Charles
Butler, and David Schenck--who made a presentation to BB & T regarding the STARS transaction. Watson, Tr. 3423-35;
Monger, Tr. 966; JX 241. At the time of this meeting, both Mr. Watson and Mr. Monger were aware that KPMG was intricately
involved in the development of the STARS transaction and that KPMG had participated in implementing two prior STARS
transactions with U.S. banks. Monger, Tr. 632; Watson, Tr. 3441. Around this time, BB & T Chief Financial Officer Scott Reed
tasked Mr. Monger with coordinating BB & T's efforts on the STARS transaction. Monger, Tr. 1045.
In its presentation to BB & T, KPMG proposed a trust asset base of $3.5 billion and a proposed loan of $1 billion. USX 343;
JX 241; Monger, Tr. 969-71; Watson, Tr. 3423-24. KPMG explained that BB & T's benefit from STARS would be based on
the U.K. tax credit and that the greater the amount of Barclays' tax credits, the greater the benefit to BB & T. Monger, Tr.
973-75; Watson, Tr. 3430. KPMG also stated that BB & T's interest charge on the loan would be reduced by half of the U.K.
tax paid by the STARS trust. Watson, Tr. 3427-28. Mr. Monger understood that, as a result of the STARS transaction, Barclays
would not receive any fee from BB & T, but rather would receive a split of tax credits. USX 343; JX 241; Monger, Tr. 992-93.
KPMG further explained that BB & T would never lose control of the assets it committed to STARS, nor would it lose control
of the income from those assets. Monger, Tr. 978-79. During the meeting, KPMG explained that the Class C Unit distribution
amounts would be paid into an account held by BB & T in Barclays' name, and that all money paid into that account would
simultaneously be returned to the trust. Although the account was held in Barclays' name, Barclays would have no control over
that account, and only BB & T employees would make transfers in and out of the account. Monger, Tr. 988-89. KPMG also
noted that BB & T might have an overall foreign loss across the consolidated BB & T group, which would limit or prevent
BB & T's ability to claim foreign *139 tax credits for the U.K. taxes paid by the trust. JX 241; USX 343; Monger, Tr. 993-94.
In the event of such a loss, KPMG suggested that BB & T may be able to avoid limitations on claiming foreign tax credits by
deconsolidating a special purpose entity BB & T employed to implement STARS. Monger, Tr. 993-94.
After this initial meeting, on January 28, 2002 Mr. Butler of KPMG sent an email to Mr. Watson and Mr. Monger. USX
366; Watson, Tr. 3432. In encouraging BB & T to implement the transaction, Mr. Butler referred to STARS as one of few
tax related opportunities to achieve significant above the line savings. USX 366. Mr. Butler also addressed the issue of a
potential overall foreign loss, stating that we also need to confirm whether, as a result of LILO investments, BB & T has
an overall foreign loss for purposes of calculating the foreign tax credit. USX 366. On February 20, 2002, Mr. Butler sent a
follow-up email, in which he stated: A deconsolidation would allow the full foreign tax credit [from STARS] to be utilized for
book and tax purposes, notwithstanding the existence (to be confirmed) of foreign losses from the LILO transactions. USX
402; Watson, Tr. 3449-51. The proposed deconsolidation would be accomplished by issuing preferred stock in the entity to be
deconsolidated; that preferred stock would need to transfer 20 percent or more of the voting interest in the entity to the preferred
stockholder. Watson, Tr. 3451-52; USX 402. BB & T eventually concluded that it would be better off going ahead and doing
the deconsolidation. Monger, Tr. 999-1000.
2. Communications with Barclays
Also in January 2002, Mr. Monger met with Messrs. Jenkins, Sultan, and Beshlian of Barclays regarding STARS. Id. at
1003-04. The Barclays representatives described the STARS transaction as applicable to BB & T, which contemplated a $1.5
billion loan to BB & T and a benefit of $44 million in the first year alone, based on the 50/50 split of the trust's U.K. tax liability
of $88 million. USX 340; Monger, Tr. 1010-11. Barclays characterized this benefit as a 293-basis-*561 point reduction in BB
& T's interest rate on the loan, which it calculated by dividing the $44 million benefit to BB & T by the $1.5 billion loan amount
to BB & T. USX 340; Monger, Tr. 1010-11.
On February 4, 2002, Mr. Ioannidis of Barclays sent Mr. Monger a clarifying email regarding the STARS projection for BB
& T. JX 242; Monger, Tr. 1012-13. Mr. Ioannidis explained Barclays' belief that STARS could be structured in a way that BB &
T could avoid paying North Carolina state taxes on the trust income. JX 242. Mr. Ioannidis also clarified that [a]ll the income
received by Barclays on the [Class C Units] will be mandatorily reinvested into additional consideration for these units. Thus,
the asset pool will increase each year, effectively generating additional income.... Over the 5 years, this accretion is expected
to result in $22 million of additional benefits for BB & T. Id. Further, Mr. Ioannidis explained that BB & T's monthly benefits
from STARS would be subject to an adjustment as a result of timing delays in [Barclays] obtaining tax credits, but noted that
BB & T will obtain the full benefit of timing delays in paying income taxes in the Trust. Id.
On February 14, 2002, Mr. Ioannidis sent Mr. Monger a memorandum entitled Project STARS Q & A. JX 243. In this
memorandum, Mr. Ioannidis revisited the possibility of BB & T avoiding state taxation. Id. He explained, [i]f InvestCo is
formed in the appropriate State and if structured correctly, then BB & T could avoid paying state income taxes on income
generated by the assets committed to STARS. Id. Mr. Ioannidis also discussed the possibility of withholding taxes, explaining
that [f]ollowing the recent changes to the U.K./ U.S. double transaction treaty, any interest payments in the transaction deemed
contingent could be subjected to a 20 percent withholding tax. Id. He further explained that to avoid any risk of withholding,
the parties needed to agree on fixed pre-determined amounts for the monthly payments from Barclays to BB & T under the
Zero Coupon *140 Swap. Id.
These monthly benefits that BB & T received from the STARS transaction were referred to as the Bx. JX 35; Monger, Tr.
1017-19. As described in the Formulae Letter, the bx is equal to 51 percent of the tax credits received by Barclays on the Class C
Unit. JX 35. Mr. Monger understood the Bx to be a sharing agreement between Barclays and BB & T, in which Barclays would
reduce BB & T's interest rate expenses based on the tax credit Barclays received. Monger, Tr. 1110-11. Contemporaneously,
Mr. Monger referred to the Bx payment as a [r]ebate from Barclays. USX 437; USX 465.
To protect itself and ensure that the taxes BB & T paid to the STARS trust were sufficient to match the necessary
predetermined Bx payments, Barclays required an indemnity provision. JX 23; Monger, Tr. 1203-04. The Expected Class C
Unit Distributions were also predetermined, as they were calculated to coordinate with the predetermined Bx payments. JX 23;
Monger, Tr. 1204-05. The combination of these predetermined amounts and distributions, along with the indemnity provision,
led Mr. Ioannidis to conclude that [t]here will not be any withholding tax in the STARS transaction. JX 243.
In mid-February, Mr. Sultan sent a memorandum to BB & T entitled STARS Benefit Analysis, which Mr. Monger received
and reviewed. JX 244. Mr. Sultan explained that the benefits [from STARS] are driven from the asset side and asset yield only.
Id. In this memorandum, Mr. Sultan also discussed the calculation of benefits that STARS would generate, noting that [t]he
benefit under STARS arises from the ability of both parties to obtain credits for the taxes paid in the Trust. Thus, the benefits
to both BB & T and Barclays are easy to calculate and are equal to 50% of these taxes for each party. JX 244; Monger, Tr.
1032-34. In describing a sample accounting of the potential benefits to BB & T, Mr. Sultan stated that [t]o calculate BB & T's
real benefit from STARS, we have to deduct the [Trust] Asset Income (which would be received by BB & T anyway). JX 244.
Mr. Monger understood Mr. Sultan's statements to mean that the benefits of the transaction were driven by the size of the
trust asset pool and the yield on those assets. *562 Monger, Tr. 1031-32. Nonetheless, Mr. Monger conducted several of his
own calculations regarding BB & T's potential economic benefits from STARS. Id. at 1037-39; USX 437. In his calculations,
Mr. Monger assumed that the use of $1.5 billion of loan proceeds from STARS and the use of $1.5 billion of loan proceeds
from an alternate borrowing would yield the same amount, and thus would cancel out. Monger, Tr. 1038-39. He did not include
the potential yield on use of the loan proceeds as an element of profit in his analysis. Id.
During this information exchange between BB & T and Barclays, BB & T began to hear that another U.S. bank had declined to
enter into a STARS transaction. On or about February 18, 2002, personnel in BB & T's funding department informed Mr. Watson
that SunTrust had rejected entering into a STARS transaction because of potential tax risk. Watson, Tr. 2857, 3443-46; USX
396. Mike Blevins of BB & T also communicated to Mr. Monger information received from SunTrust employees, that [t]hey
didn't pursue the transaction because of their concern over long-term tax implications, and the status of their foreign tax credit.
USX 388; Monger, Tr. 678, 681-82. Mr. Monger relayed this information to Mr. Watson and Mr. Reed. Monger, Tr. 682-83;
USX 388. Mr. Watson then investigated this information by calling Deborah Jameson, the tax director of SunTrust. Watson,
Tr. 2856-58. Mr. Watson testified that in their correspondence, Ms. Jameson told him that she had liked the transaction, but
did not have the time to conduct proper due diligence on it. Id. at 2858.
3. Discussions Regarding STARS Tax Risks
On February 26, 2002, Mr. Reed gave a presentation to BB & T Corporation's Board of Directors, in *141 which he informed
the Board of the potential STARS transaction. JX 245; PX 29. Mr. Reed described the expected benefit to BB & T from STARS
as one-half of UK tax credit received by investor [Barclays] for UK income taxes paid by Trust. [FN5] PX 29; Monger,
Tr. 1045-46, 1051-52; Watson, Tr. 3452-55. Two days later, on February 28, 2002, Mr. Ioannidis sent Mr. Monger an email
showing Barclays' analysis and allocation of BB & T tax risks as a result of STARS. USX 453; Monger, Tr. 1145-48. Under
Barclays' allocation of tax risk, the U.S. tax repo risk falls with BB & T and the risk of Barclays getting the tax credits falls with
Barclays. USX 453. However, the risk that the STARS trust would be found either not a tax-resident or a collective investment
scheme in the U.K. would be shared between Barclays and BB & T. Id.
From the outset, in BB & T's and KPMG's discussions regarding STARS, KPMG informed BB & T that the transaction
involved tax risks. Watson, Tr. 3461. During the course of multiple meetings and correspondence among BB & T, Barclays,
and KPMG, the potential downside risks and tax ramifications of STARS were discussed. See, e.g., USX 431; JX 247. One
of these downside risks was the possible situation in which BB & T was not allowed to take the full foreign tax credit, but
was nevertheless allowed to take a deduction on its U.S. tax returns for the U.K. tax it paid. JX 247; Monger, Tr. 1097-98.
Mr. Monger relied upon KPMG's representations that deducting the U.K. taxes paid in STARS would be possible, and did not
obtain any independent analysis. Monger, Tr. 1100. At the time of KPMG's representations in March 2002, Mr. Monger knew
that KPMG had not been paid for any of its work on BB & T STARS, and that KPMG would not be paid for its work if BB
& T decided not to close the transaction. Id. at 1100-01.
Mr. Monger did, however, prepare his own calculation of BB & T's potential downside U.S. tax risk. USX 437; Monger,
Tr. 1105-06; Watson, Tr. 3465. On March 8, 2002, he circulated his Illustration of Downside Risk to Messrs. Watson and
Butler, in which he referred to the potential $44 million benefit to BB & T as a Rebate from Barclays. USX 437; Monger, Tr.
1108-10; Watson, Tr. 3465-66. This rebate was precisely half of *563 the $88 million listed as U.K. taxes payable in STARS
and the $88 million in projected foreign tax credits. USX 437. This illustration also showed the interest expense for borrowing
the $1.5 billion (at 5.25 percent) as $78,750,000, an expense not reduced by the $44 million rebate that BB & T expected to
receive from Barclays. Id. In making these calculations, Mr. Monger assumed that the yield to BB & T on the $1.5 billion loan
proceeds would be identical to the cost of borrowing that amount: 5.25 percent. JX 247; Monger, Tr. 1113-14. In order to isolate
the profit attributable to the STARS transaction, Mr. Monger made a typical banking assumption that BB & T would realize
no profit on the $1.5 billion loan proceeds. Monger, Tr. 1114-15. At the time when Mr. Monger prepared these calculations, he
knew of the possibility that the monthly rebates from Barclays could offset BB & T's monthly interest payments. Id. at 1111-12.
This scenario would result in Barclays making net monthly payments to BB & T, which would be characterized as negative
interest on BB & T's tax returns and financial statements. Id. In correspondence that followed the circulation of Mr. Monger's
calculations, Messrs. Monger and Butler agreed that the amount of BB & T's tax risk or downside was equal to the amount
of BB & T's potential benefit from STARS. Id. at 1122.
On March 20, 2002, Mr. Butler sent a formal letter to Mr. Reed, addressing the tax risks BB & T faced from STARS. Monger,
Tr. 1126-27; Watson, Tr. 3466; JX 250. Messrs. Monger and Watson had previously reviewed this letter, and knew that the
tax *142 risks to BB & T included the inability to claim foreign tax credits, a finding that the transaction lacked economic
substance, and the potential for an IRS assessment of penalties. Monger, Tr. 1102-04, 1126-37; Watson, Tr. 3466-68; JX 248.
On March 21, 2002, Mr. Butler sent an email to Mr. Sultan in which he recapped a meeting he had with Messrs. Reed,
Monger, and Watson, and Sherry Kellet of BB & T. Monger, Tr. 1151-52; USX 470. The meeting participants had discussed
KPMG's risk assessment, which was satisfactory to BB & T. USX 470; Monger, Tr. 1155. The participants also negotiated
KPMG's fees. USX 470; Monger, Tr. 3469-73. KPMG initially requested $8 million in fees on the STARS transaction, but
BB & T sought to reduce its exposure in the event of an early termination of the transaction. USX 470; Watson, Tr. 3469-70;
Monger, Tr. 1156-57. KPMG offered to provide future services supporting the foreign tax credit calculations, and thereby
defer $2 million of the requested fees. USX 470. Ultimately, BB & T negotiated an agreement in which KPMG would provide
approximately 350 hours of professional service if the STARS transaction was examined or challenged by the IRS on audit.
Watson, Tr. 3471-73, 3622-25; JX 254.
That same day, BB & T announced that it had fired the Arthur Andersen accounting firm as its outside auditor and had
engaged PwC in that capacity. Monger, Tr. 1152-53; USX 470. In March and April 2002, BB & T provided PwC with materials
to review the proposed STARS transaction. USX 465; Monger, 1248-51.
KPMG and BB & T continued to negotiate KPMG's fees, and on March 27, 2002, Mr. Monger proposed a fee deferral similar
to the fee arrangement in the OTHELLO transaction, where payment was deferred until the deal had either closed or been
examined by the IRS. USX 485. On April 2, 2002, Mr. Butler sent an email to KPMG's Vice Chairman, reporting a verbal
agreement on KPMG's fee for the transaction. USX 2238. Mr. Butler explained that [t]he transaction will still be contingent
upon PWC signing off on the tax and accounting treatment. Id. Mr. Monger also believed that BB & T's participation in STARS
would only occur if PwC signed off on the transaction. Monger, Tr. 1190-93.
On April 5, 2002, BB & T and KPMG entered into an engagement letter agreement for tax advisory services related to STARS.
Monger, Tr. 1193; JX 254. The agreement provided that BB & T would pay KPMG $6.5 million in fees for its work on BB & T
STARS, and of that amount, $500,000 would be deferred for each of the five projected years of STARS. Monger, Tr. 1196; JX
254. These fees were to cover implementation *564 assistance, 350 hours of examination assistance and U.S. opinion. JX 254.
BB & T's Executive Management committee planned to meet on April 8, 2002, and Mr. Monger requested that Barclays and
KPMG send representatives to this meeting. PX 36; Monger, Tr. 1148-49. Together with Mr. Monger, Mr. Ioannidis prepared
a presentation on BB & T's exposure to tax risks related to the STARS transaction and KPMG's assessment of those risks.
PX 36; Monger, Tr. 1148, 1217, 1224-27; JX 255. A few days before the committee meeting, Mr. Butler circulated a draft
opinion memorandum on the U.S. tax consequences of STARS to Messrs. Monger, Watson, and Cox. Watson, Tr. 3473; PX
46. Mr. Watson provided PwC with a copy of the KPMG memorandum, as well as a copy of a redacted STARS legal opinion
from Sidley Austin. Watson, Tr. 3501-02. BB & T did not ask PwC to issue its own opinion on the STARS transaction, id. at
3502-03, even though BB & T's participation in STARS was contingent upon PwC being comfortable with the transaction at
a high level, id. at 3495-500, USX 529, Monger, Tr. 1238-47.
On April 17, 2002, Messrs. Monger and Ioannidis exchanged emails regarding STARS. USX 559; Monger, Tr. 1227-38.
Mr. Monger inquired whether *143 Barclays would be willing to increase the size of the borrowing in STARS or the size
of the trust and therefore the size of the tax credits. USX 559. Mr. Ioannidis replied that Barclays likely would be interested
in increasing the size of the trust and hence the benefit for both parties, but noted that an increase in the loan size might
be more difficult. Id. During the next few weeks, Messrs. Monger and Watson conferred with representatives from KPMG
and PwC regarding opinion levels and downside risk potential to BB & T from STARS. Watson, Tr. 3504-05; Monger, Tr.
1251-55. In particular, the transaction participants discussed whether BB & T would be able to deduct the U.K. tax payments
on its U.S. returns in the event that STARS was determined to lack economic substance. USX 564. Mr. Watson asked KPMG
to research that issue, as the loss of a deduction would add significantly to BB & T's potential downside risk. Watson, Tr.
3506-08. Mr. Butler concluded that deductions would only be disallowed if a court believed you engaged in such a sham that
they would not even allow economic losses.... I am assuming we [KPMG] believe such a chance is so remote as to not need
to be considered. USX 564.
On April 30, 2002, Mr. Ruble of Sidley Austin sent Mr. Monger a redacted favorable tax opinion regarding STARS, which
Mr. Watson also reviewed. USX 599; Monger, Tr. 1265-66; Watson, Tr. 3508-09. KPMG had recommended Mr. Ruble and
his law firm to BB & T because of his work on previous STARS transactions. Watson, Tr. 3511-12. At the time of Mr. Ruble's
April 30 email forwarding the tax analysis opinion, BB & T and Sidley Austin had not reached a fee agreement for work on
STARS. Monger, Tr. 1267.
On May 7, 2002, BB & T formally engaged Sidley Austin for the STARS transaction. Monger, Tr. 1295; JX 264. The
engagement letter provided that BB & T would pay Sidley Austin a flat fee for its Tax Representation, with the amount
dependent on the need for deconsolidation. Monger, Tr. 1295-97; JX 264. Tax Representation included federal income tax
advice and the provision of a tax opinion on STARS. JX 264. All other legal advice and documentation with respect to STARS
was defined as Corporate Representation, which would be billed at Sidley Austin's usual hourly rates on a monthly basis. Id.;
Monger, Tr. 1296-97. The engagement letter also contained a waiver by BB & T of any legal conflict with Sidley Austin's past
and potential future representation of Barclays Bank and its affiliates. JX 264.
4. Negotiation of STARS
In early May 2002, representatives from BB & T and KPMG discussed whether BB & T would have an overall foreign loss
from its LILO transactions, and if so, how BB & T's STARS transaction could be structured to preserve BB & T's ability to claim
foreign tax credits. Monger, Tr. 1267-68; Watson, Tr. 3513-14; PX 68. BB & T provided KPMG with detailed information on
the LILO and SILO transactions BB & T had *565 engaged in between June 1997 and July 2001. Watson, 3515-16; PX 68. From
this information, KPMG calculated that, through December 31, 2001, BB & T had a cumulative tax loss on the transactions of
$1.4 billion. Watson, Tr. 3516; PX 68. KPMG stated that BB & T would have a current overall foreign loss in subsequent years.
PX 68. Therefore, KPMG concluded that it will be necessary to structure the STARS transaction through a deconsolidated
entity that will generate passive basket income in order to utilize the credits generated by STARS. Id. Based on its projected
overall foreign loss, BB & T decided to deconsolidate InvestCo as part of STARS. Watson, Tr. 3516-17, 3521. [FN6]
The Participation Agreement for BB & T's *144 STARS transaction provided that BB & T would indemnify Barclays for
losses if the BB & T STARS trust was not found to be a U.K. resident or a collective investment scheme under U.K. law.
Monger, Tr. 1302- 03; JX 17. At this time, BB & T had no U.K. or other foreign presence, and Mr. Monger expressed concern
regarding the foreign tax treatment of the STARS trust. PX 67. Given that KPMG was on both sides of the U.K. residency
risk because of its representation of Barclays, PX 67, Sidley Austin provided a U.K. legal opinion on the issue. Monger, Tr.
1301-02; JX 287.
On May 20, 2002, Nicholas Vasudeva of Barclays circulated an email and memorandum to BB & T and Barclays
representatives containing an analysis of the comparative benefits of STARS to BB & T and Barclays. Monger, Tr. 1309-10;
Watson, Tr. 3563-67; JX 267. In one of these documents, Mr. Vasudeva stated that BB & T's proposed split of the benefits is
50 percent of the UK tax credit available to Barclays as holder of the C and D Units. JX 267. Mr. Vasudeva also separately
set forth the U.K. tax loss Barclays expected to receive, stemming from the receipt and mandatory return of the monthly Class
C Unit distributions. Id. Based on Mr. Vasudeva's memorandum, Mr. Monger generated his own calculation of the various
benefits Barclays would claim from STARS, in addition to the tax credits on taxes paid by the STARS trust. Monger, Tr. 1316.
Based on his own calculations, Mr. Monger asked that BB & T receive a higher percentage of U.K. tax rebates from Barclays,
from 50 percent to 51 percent, which was agreed to by the parties. Monger, Tr. 1316.
On May 29 and 30, 2002, participants from BB & T, KPMG, Sidley Austin, and Barclays held a meeting in New York City
regarding STARS. Id. at 1317-18; PX 77. After the meeting, KPMG circulated follow-up documents, including a calculation
that BB & T could be exposed to a $2 million alternative minimum tax as a result of its participation in STARS. Monger, Tr.
1318-19; PX 77. KPMG suggested that BB & T consider this additional cost in finalizing negotiations with Barclays on the
benefit split and breakage fee. PX 77.
On June 5, 2002, the associate general counsel of BB & T sent a letter to the North Carolina Commissioner of Banks, seeking
a non-objection letter for BB & T's participation in STARS. Monger, Tr. 1322-23; USX 661. In this letter, BB & T represented
that it expected the transaction to add approximately $25 million of after-tax benefits per annum to BB & T, or, approximately
$125 million of benefits over the entire projected term of STARS. USX 661. BB & T also stated that its ability to receive
the after-tax benefits described was predicated on interpretations of both United States and United Kingdom tax laws and
regulations. Id.; Monger, Tr. 1323.
On June 17, 2002, Mr. Ioannidis sent an email to the STARS team members at BB & T, KPMG, Sidley Austin, and Barclays
Capital, which included a draft formula letter, formula and cash flow examples, and a spreadsheet model for the numbers in the
formula letter. Monger, Tr. 1209-17; USX 690. The draft formula letter discussed the makewhole payment, explaining:
In summary, this payment compensates Barclays if the distributions out of the Trust (and hence tax credits) are less than
*566 agreed at the start. Barclays needs to be compensated, because it has already paid BB & T a spread based on the agreed
distributions. As discussed, the reason why the spread has to be pre-determined is in order to avoid potential withholding tax
on interest payments under the Zero Coupon Swap under the new U.S./U.K. Double Taxation Treaty.
USX 690 at 13. The draft formula letter clarified that the make-whole amount would be equal to the lost tax credits to Barclays
due to the lower trust income. Id. Mr. Monger understood that this payment would *145 be due at the termination of STARS
unless BB & T made up any shortfalls in Class C Unit distributions. Monger, Tr. 1213-15. BB & T had an economic incentive
not to allow such shortfalls, as BB & T could not claim foreign tax credits for payments made to Barclays. Id. at 1215-16.
On June 27, 2002, the Board of Directors of BB & T met to discuss the STARS transaction originally presented to the Board
in February 2002, and to learn additional details regarding the proposed transaction. USX 728 at 1-3, 7-9. After Mr. Reed
gave the presentation, the directors adopted a resolution approving BB & T's participation in STARS. Id. at 5-9. The Board of
Directors for the BB & T holding company also approved the transaction on or about the same day. Monger, Tr. 1326-27. BB
& T's STARS transaction closed on August 1, 2002. Johnson, Tr. 496; Monger, Tr. 1195-96; JX 1.
5. Post-Closing Communications
On August 27, 2002, Mr. Watson informed Mr. Reed of the possibility that BB & T would be subject to an alternative
minimum tax due to its participation in the STARS transaction, and suggested a reassessment of tax-favored investments in
order to avoid such a tax. Watson, Tr. 3526-31; USX 941.
On October 1, 2002, Mr. Reed sent to KPMG BB & T's representations to be used by KPMG in issuing its tax opinion on
STARS. Monger, Tr. 1351-54; Watson, Tr. 3539-42; JX 281. KPMG had previously written the representations letter, and
transmitted it to BB & T for review and signature. Monger, Tr. 1352-55. That same day, Mr. Butler circulated within KPMG
a final draft of KPMG's tax opinion on BB & T STARS. Watson, Tr. 3552-53; USX 1005.
On October 11, 2002, KPMG sent Mr. Monger an analysis on Deductions for Foreign Taxes Paid if BB & T was not
entitled to claim foreign tax credits. Watson, Tr. 3531-36; JX 284. KPMG stated that BB & T should be entitled to a deduction
under section 162, 164 or 165 [of the Internal Revenue Code] in the event they are not entitled to a section 901 or section 903
foreign tax credit. JX 284.
On February 24, 2003, Mr. Monger sought Mr. Ioannidis' opinion on the disclosures BB & T planned to include regarding
STARS in its annual Form 10K report to the Securities & Exchange Commission. Monger, Tr. 1356-58; USX 1163. Mr.
Ioannidis responded that referring to a trust in the income tax note was tricky, and that Barclays may have a small preference
for simply stating that these foreign taxes were incurred in the context of a financing deal with a foreign lender. USX 1163. In
March 2003, BB & T filed its annual Form 10K for the period ending December 31, 2002. Monger, Tr. 1358-63; JX 209. The
filing did not refer to a trust, but instead stated, consistent with Mr. Ioannidis' advice, that [t]he foreign income tax expense
included in the 2002 provision for income taxes is related to income generated on assets controlled by a foreign subsidiary of
Branch Bank. JX 209.
On April 7, 2003, Sidley Austin issued its U.K. tax opinion on BB & T STARS, addressing the issues of U.K. tax residency
and the characterization of STARS as a collective investment scheme under U.K. law. Monger, Tr. 1347-52; Watson, Tr.
3536-39; JX 287.
On September 19, 2004, InvestCo filed its U.S. Corporation Income Tax Return for the year ending December 31, 2003.
Watson, Tr. 3596-99; JX 234.
E. Implementation and Structure of BB & T STARS [FN7]
*146 In marketing the STARS transaction, Barclays and BB & T used generic names to *567 identify the various entities
that would be used in setting up the STARS structure. The generic names were designed to be suggestive of the role that each
entity would play in the structure. Thus, in the section below, following the promoter's naming convention, the Court will
identify names such as InvestCo, Manager, NewCo, and DelCo. All of the necessary structure and entities were created within
a span of one week. Monger Tr. 583.
The references to Class A, B, C, D, and E Units are simply nomenclature to describe ownership rights of the various entities
and the transfers that would occur in the STARS transaction. Despite the many components and entities making up the STARS
transaction, the real parties in interest at all times were BB & T Bank and Barclays Bank. The transaction also consists generally
of a trust (Trust) and a loan (Loan).
1. Creation and Funding of the STARS Structure
Branch Investments LLC (InvestCo) was a wholly owned subsidiary of BB & T. Stip. 4. InvestCo was a pre-existing
investment holding company formerly known as Skylight Investment Corporation, and was organized under the laws of the
state of Delaware. Stip. 4, 16. On July 26, 2002, InvestCo formed Branch Management LLC, known as Manager, a wholly
owned Delaware corporation for U.S. federal income tax purposes. Stip. 5, 11. InvestCo acquired all of the issued and
outstanding shares of Manager in exchange for $100,000 in cash. Stip. 11. BB & T retained control of Manager. Cragg, Tr.
4461-62; USX 661 at 5.
On July 26, 2002, InvestCo also formed Branch Holdings LLC (NewCo). Stip. 12; JX 283 at 3897. InvestCo organized
NewCo as a wholly owned Delaware limited liability company. JX 283 at 3897. NewCo did not issue any membership interests
until September 12, 2002. Stip. 12; JX 283 at 3897. BB & T retained control of NewCo. Cragg, Tr. 4460; USX 661 at 5.
Prior to executing STARS, BB & T held all of the common stock of Matewan Real Estate Holdings, Inc. JX 283 at 3896.
On July 29, 2002, Matewan REIT executed an exchange of its common stock with BB & T. Stip. 13. On July 29, 2002, BB
& T transferred 2,000 shares of its Class A Matewan REIT Stock in exchange for 2,000 shares of Class B REIT Stock. Stip.
14; JX 283 at 3896.
On July 29, 2002, InvestCo converted to a limited liability company and changed its name from Skylight Investment
Corporation to Branch Investments LLC. Stip. 16; JX 283 at 3896. InvestCo held $414 million in investment securities as of
July 30, 2002. Stip. 17. BB & T controlled InvestCo. Cragg, Tr. 4460; USX 661 at 5.
On July 29 and 30, 2002, BB & T contributed approximately $5.755 billion in assets to InvestCo in exchange for additional
common shares of InvestCo valued at $5.755 billion. Stip. 18. The assets contributed to InvestCo consisted of the Matewan
Class B REIT Stock, automobile loans, constant credit loans, first deed loans, and other assets. Stip. 15, 18. At the conclusion
of this step, InvestCo held approximately $6.169 billion in assets, consisting of $5.755 billion contributed from BB & T, and
$414 million in investment securities already held by InvestCo. Stip. 17, 19.
On July 30, 2002, InvestCo formed Branch Finance LLC, known as DelCo. InvestCo contributed $6.080 billion in assets
and $10,000 in cash to DelCo. Stip. 20. In return, DelCo issued two classes of *147 shares to InvestCo: (a) $65 million in
Class I voting shares with rights to receive approximately 1 percent of any DelCo distributions; and (b) $6.015 billion in Class
II non-voting shares with rights to receive approximately 99 percent of any DelCo distributions. Id. Thereafter, InvestCo owned
all of the issued outstanding shares in DelCo. Stip. 21. DelCo owned $6.080 billion in income-producing assets and $10,000
in cash transferred from BB & T via InvestCo. Stip. 22. BB & T controlled the DelCo distributions through its ownership of
the Class I shares. Cragg, *568 Tr. 4460; USX 661 at 5. Of the approximately $6 billion owned by DelCo, $1.5 billion served as
collateral for the Loan, and the remaining $4.5 billion generated income for the required revenue stream. Johnson, Tr. 175-76.
Branch Funding Trust, known as Trust, was established on July 30, 2002. Stip. 23; JX 283 at 3895. The Trust was
100 percent owned by InvestCo. Stip. 23. The Trust Agreement that created the Trust also delegated management and
administration of the Trust to Manager, which was controlled by BB & T. Stip. 23; Cragg, Tr. 4461-62; USX 661 at 5.
On July 30, 2002, InvestCo contributed its DelCo Class II non-voting stock and $89 million in assets to the Trust. Stip. 24.
In return, the Trust issued to InvestCo (a) the Class A Units with an aggregate stated value of $4.604 billion, and (b) the Class
B Unit with a stated value of $1.5 billion. Id.; JX 283 at 3897-98.
On August 1, 2002, Barclays provided $1.5 billion in cash to the Trust in return for a Class C Unit with a stated value of
$1,474,999,000, a Class D Unit with a stated value of $25 million, and a Class E Unit with a stated value of $1,000. Stip. 26.
Despite the Barclays Unit purchase, BB & T retained control over the Trust. Cragg, Tr. 4461-62; USX 661 at 5. Also on August
1, 2002, using the cash received from Barclays, the Trust immediately redeemed InvestCo's Class B Unit for $1.5 billion in cash.
Stip. 32. This step completed the transfer of $1.5 billion in financing from Barclays to the BB & T Group through the Trust. Id.
On the closing date of August 1, 2002, InvestCo transferred 50 percent of the Trust's Class A Units to NewCo in return for
a 100 percent membership interest in NewCo. Id. 34. Contribution of 50 percent of the Class A Units in the Trust to NewCo
created a second member in the Trust, allowing it to elect to be classified as a partnership for U.S. tax purposes. JX 283 at 3943.
On August 1, 2002, InvestCo issued preferred shares to Asteras (to be addressed below) in return for $65 million in cash. Stip.
30. Of the amount invested by Asteras, $64.75 million was loaned to Asteras by a wholly owned subsidiary of Barclays. Id. The
remaining $250,000 came from an entity known as GSS Holdings. Cragg, Tr. 4554-55. Also on August 1, 2002, InvestCo loaned
the proceeds from the Class B redemption ($1.5 billion) and the preferred stock issuance ($65 million) to two state-chartered
BB & T banking subsidiaries, Branch Banking and Trust Company of Virginia and Branch Banking and Trust Company of
South Carolina. Stip. 33.
The Trust and DelCo each filed a form 8832 with the IRS, electing to be classified as partnerships for U.S. tax purposes.
Id. 35. On August 2, 2002, Branch Administrators Limited, also known as the U.K. Trustee (Trustee), was formed as a
U.K. incorporated company established under the laws of England and Wales. Id. 36. In exchange for interests in the Trustee,
InvestCo and DelCo funded the Trustee with $990,000 and $10,000 in cash, respectively. Id.
On August 8, 2002, the U.K. Trustee replaced the U.S. Trustee as the trustee of the Trust pursuant to the Trustee Accession
Agreement. Id. 37. The U.K. residence of the Trustee made the income of the Trust subject to U.K. tax. Cragg, Tr. 4462; Demo.
Ex. 15; *148 USX 607 at 5. BB & T nevertheless retained control of the Trustee. USX 661 at 5. The Trustee's responsibilities
were limited to administrative activities. Cragg, Tr. 4462-63; Demo. Ex. 13; JX 243 at 2394.
2. Changing Barclays' Trust Unit Purchase Into a Collateralized Loan
Barclays and InvestCo executed two forward sale agreements (addressed below), including one related to the Class C and
E Units, and the other related to the Class D Unit. Stip. 28. The combined effect of the forward sale agreements was that
InvestCo agreed to purchase the Class C, D, and E Units from Barclays at the termination of the transaction for a price equal
to the total original subscription amount of $1.5 billion, plus an amount calculated by reference to a fixed interest rate, known
as the accretion. Id. The forward sale agreements had a stated maturity date of August 15, 2007 (a term of approximately
five years), but could be *569 terminated by either party with 30 days' notice. Stip. 57-59. InvestCo's obligations to Barclays
were collateralized by $2.14 billion in assets ($391 million in investment securities and $1.75 billion in auto loans). Stip.
53-56. In addition, BB & T guaranteed InvestCo's obligations to Barclays in the STARS transaction. Stip. 27.
Barclays and InvestCo also simultaneously executed a Zero Coupon Swap Agreement (addressed below), which effectively
converted InvestCo's fixed-interest-rate obligation payable at termination pursuant to the Class C Unit and Class E Unit forward
sale agreement into a floating rate interest obligation payable monthly. Stip. 29. This floating interest obligation was calculated
as the product of (a) a notional principal amount of $1.475 billion and (b) a floating rate tied to the one-month LIBOR rate. Id.
Also as part of the Zero Coupon Swap Agreement, the floating interest obligation was offset against a separate predetermined
amount characterized in the closing documents as the Floating Rate Spread Amount or the Bx. Id. The fixed leg of the
Swap Agreement required Barclays to pay a fixed amount at termination, which was exactly equal to the accretion. Cragg, Tr.
4573-74; JX 20 at 431.
The accretion payment from BB & T to Barclays calculated by reference to the fixed interest rate contained in the Class C
Unit and Class E Unit forward sale agreement was designed to be exactly offset by an identical payment from Barclays to BB &
T in the Zero Coupon Swap Agreement. Cragg, Tr. 4571-74; Demo. Exs. 153-56. The net effect of Barclays' purchase of Trust
units, the forward sale agreements, and the Zero Coupon Swap Agreement was to provide BB & T with $1.5 billion in funding
from Barclays at a floating rate of approximately one-month LIBOR plus 25 basis points, and the payment of a monthly Bx
amount from Barclays to BB & T. Cragg, Tr. 4577-78; Demo. Ex. 159.
3. Cash Flows Associated With the STARS Structure
The Trust received 99 percent of the monthly distributions as the holder of DelCo's Class II ordinary stock, and InvestCo
received one percent of the monthly distributions as the holder of DelCo's Class I ordinary stock. Stip. 38. InvestCo determined
the magnitude of these distributions through its ownership of the DelCo Class I ordinary stock. InvestCo could cause DelCo to
make distributions in excess of its income, by distributing capital. Stip. 20; Cragg, Tr. 4486; Demo. Ex. 48. Each month, the
Trust paid the Manager a fee to compensate the Manager for managing the assets of the Trust. Stip. 50.
After payment of the Manager's fee, the remaining Trust income was subject to U.K. tax liability. Stip. 39; Coffield, Tr.
4420-21. These U.K. taxes were payable semi-annually at a rate of 22 percent. Stip. 39, 63. To pay these taxes in the United
Kingdom, the Trust set aside a portion of the cash received (the Tax Amount) each month in a tax set-aside account held
at Barclays. Stip. 39. Since the Trust was required to pay tax in British pounds sterling while the cash received by the Trust
was in U.S. dollars, the Trust exchanged the Tax Amount for an amount of British *149 pounds sterling at the prevailing
exchange rate. Id.
After deducting the Manager fee and setting aside funds to pay the U.K. taxes, the Trust distributed its remaining cash to
its unit holders pursuant to the Trust Agreement in the following order: (1) Class A Units--one percent of the Trust's income
(proceeds split evenly between InvestCo and NewCo, as each of those entities held 50 percent of the Class A Units); (2) Class
D Unit-- LIBOR-based distribution to Barclays based on the $25 million D Unit stated value; (3) Class C Unit--all remaining
distributable income. No distributions were made on the Class B Unit (which had been redeemed) and the Class E Unit (which
had no distribution rights). Stip. 32, 40. The Class C Unit distribution was placed into the Barclays Blocked Account, held
in the name of Barclays at BB & T and described in the Bank Agreement. JX 18. The precise amount of the C Unit distributions
was specified in the Class C Unit and Class E Unit forward sale agreement. JX 23 at 478-80. The C Unit distributions were
approximately 99 percent of the Trust's remaining income after payment*570 of the U.K. tax. Cragg, Tr. 4495; Demo. Ex. 66.
At the time they entered into the STARS transaction, the parties agreed to a schedule of expected monthly Class C Unit
distributions set forth in the Class C Unit and Class E Unit forward sale agreement. Stip. 41; JX 23 at 478-80. The Class C
Unit distributions were required to be paid each month into the Barclays Blocked Account at BB & T. Stip. 41. The amount
of the monthly distribution ranged between approximately $25 million and $35 million. Cragg, Demo. Ex. 33. Barclays had
no authority to withdraw funds from this account. Id. At the closing date, Barclays irrevocably directed that all funds paid
into the Barclays Blocked Account be returned to the Trust on the same day (or as soon as practicable thereafter). Id. In every
month the STARS transaction was in effect, the Class C Unit distribution was made in exactly the target amount, and these
distributions were always returned to the Trust on the same day. Cragg, Tr. 4474-75; Demo. Ex. 36; Stip. 41. While the
distributions differed somewhat from month to month, this variation is explained by the differing number of days across time
periods. Cragg, Tr. 4473-74; Demo. Ex. 34.
Each month the Trust would distribute income to the Class D Unit holder (Barclays) equal to (one-month U.S. dollar LIBOR
+ 25 basis points) 0.875 $25,000,000 (the stated amount of the Class D Unit). Stip. 42.
Barclays was obligated, pursuant to the Class C Unit, Class D Unit and Class E Unit Subscription Agreement, to return
all Class C Unit cash distributions received from the Trust back to the Trust via the Barclays Blocked Account. Stip. 43.
These returns of funds were represented by the parties to be further investment in the Class E Unit. Id. However, further
investments in the Class E Unit did not increase the Class E Unit distributions because the Class E Units were not entitled to
Trust distributions, Stip. 40, and did not affect the price at which the Class E Unit would be repurchased by BB & T under
the forward sale agreement. Cragg, Tr. 4497-99; JX 23 at 476. The Trust then took the returned Class C Unit distributions and
purchased additional DelCo Class II shares. Cragg, Tr. 4500; USX 918 at 30-31. The Trust's increased investment in DelCo
Class II shares did not increase its rights to DelCo distributions. Cragg, Tr. 4501; JX 7 at 111.
Under the forward sale agreements, InvestCo agreed at the termination of the STARS transaction to purchase, and Barclays
agreed to sell, the C, D, and E Units at a predetermined price consisting of $1.5 billion plus a fixed amount. Stip. 44. The fixed
amount was calculated by multiplying $1.5 billion by 4.43 percent (the five-year swap rate of 4.18 percent plus a spread of 25
basis points) less the Bx amount. Id. The parties simultaneously executed the Zero Coupon Swap Agreement that effectively
converted BB & T's fixed-rate obligation payable at termination under the *150 Class C Unit and Class E Unit forward sale
agreement into a floating rate interest obligation payable monthly. Id. 45. Under the floating leg of the Zero Coupon Swap
Agreement, Barclays received from InvestCo a variable payment calculated by multiplying $1.475 billion (the Class C stated
value) by (one-month U.S. Dollar LIBOR + 25 basis points) minus the Bx (referred to in the Swap Confirmation as the Floating
Rate Spread Amount). Id.
The parties agreed to a schedule of specific Bx payments at the inception of the transaction. Stip. 47. Over the expected
60-month period of the STARS transaction, the monthly Bx payment ranged from a low of $3,633,996 (month 7) to a high
of $5,650,566 (month 1). Id.
Each month, InvestCo's floating interest obligation and Barclays' Bx obligation were netted against each other. Stip. 46. In
instances where InvestCo's floating interest obligation exceeded Barclays' Bx obligation, InvestCo would make a payment to
Barclays. Id. In instances where InvestCo's floating interest obligation was less than Barclays' Bx obligation, Barclays would
make a payment to InvestCo. Id. From September 2002 until mid-2005 (nearly three years), Barclays made monthly payments
to InvestCo under this agreement. Coffield, Tr. 4433-34; Stip. App. A. In 2003, the Barclays payments to InvestCo exceeded
$25 million, and in 2004, *571 they were more than $26 million. Stip. App. A. Banks, in making a loan, do not normally pay
interest to the borrower. Monger, Tr. 1113.
Over the life of the transaction, InvestCo agreed to pay to Asteras quarterly dividend payments at a rate of one-month dollar
LIBOR + 35 basis points multiplied by the $65 million stated value of its preferred stock. Stip. 49. Asteras was obligated to
make payments to Barclays' subsidiary, Barclays Oversight Management, Inc. (BOMI) at a rate of one-month dollar LIBOR
+ 24 basis points multiplied by $64,750,000, the amount Asteras had borrowed from BOMI to acquire the preferred shares. Id.
The detailed spreadsheet used by the parties to analyze the STARS cash flows disregarded Asteras, and treated Barclays as the
recipient of the preferred dividend. Cragg, Tr. 4555-56; Demo. Ex. 134.
The amount of Trust income placed into the U.K. tax set-aside account was used to pay U.K. taxes as they became due. Stip.
48. The Trust's payment of U.K. taxes generated the foreign tax credits claimed by BB & T. JX 241 at 187488. The Trustee,
acting through the Manager in its management and administration capacity, made U.K. tax payments from the U.K. tax set-
aside account to the U.K. taxing authority. Stip. 48. Pursuant to U.K. law, the Trust's taxable years ended on April 5 each
calendar year, triggering the following events: (a) payment by January 31 of 50 percent of the estimated tax due for the year;
(b) payment by July 31 of the remaining 50 percent of the estimated tax due for the year; and (c) payment by the following
January 31 of the balance due, if any, as evidenced in the concurrently filed tax return. Id.
4. Loan
Barclays and BB & T created the $1.5 billion STARS Loan component with subscription agreements and two types of
derivative contracts known as a forward sale agreement and a zero coupon swap, discussed above. JX 14; JX 19; JX 20; JX
23; JX 24; JX 36; JX 38. Barclays transferred $1.5 billion in cash to BB & T by means of the subscription agreements at the
beginning of the STARS transaction. JX 14; JX 38. On the August 1, 2002 closing date, Barclays subscribed for, or purchased,
the STARS Trust's C, D, and E Units for $1.5 billion. Cragg, Tr. 4466; Demo. Ex. 21; JX 2 at 9-10; JX 38. By using this
method, Barclays briefly placed the $1.5 billion in the Trust. JX 38 at 855-56. With this $1.5 billion, the parties put a value of
$1,474,999,000 on the C Unit, a value of $25 million on the D Unit, and a value of $1,000 on the E Unit. JX 2 at 9-10.
A forward sale agreement is an agreement to sell *151 an asset at a future date for a price that is agreed to on the date of the
agreement. Kawaller, Tr. 4874. Barclays and BB & T entered into two forward sale agreements: (a) a Class C Unit and a Class
E Unit Forward Sale Agreement, and (b) a Class D Unit Forward Sale Agreement. Kawaller, Tr. 4873-74; JX 23 at 468-83; JX
24 at 484-94. Under these agreements, Barclays committed to sell, and BB & T (through InvestCo) committed to buy the C, D,
and E Units at the end of the STARS transaction. Kawaller, Tr. 4884-85; JX 23 at 470; JX 24 at 486.
Although Barclays originally subscribed for these units from the Trust entity directly, Barclays agreed to forward sell the C
and E Units at termination for $1.475 billion and agreed to forward sell the D Unit at termination for $25 million. Kawaller,
Tr. 4884-85; JX 2 at 9-10; JX 23 at 470; JX 24 at 486, 491. InvestCo agreed to forward buy the C, D, and E Units for these
amounts. Id. The Class C and E Unit Forward Sale Agreement did not discuss or recognize the mandatory return of the Class
C Unit distributions each month, characterized as reinvestments in the Class E Unit, and did not allow for an increase in the
sale price on the Class E Unit commensurate with these additional payments. JX 2 at 11; JX 23 at 470; USX 918 at 36, 40. This
arrangement assured that at the end of the transaction Barclays would receive only the $1.5 billion that it originally put into the
transaction. Id. The forward sale prices for the C, D, and E Units were due to Barclays at termination, when Barclays was to
transfer these units to InvestCo. JX 23 at 470; JX 24 at 486.
*572 The Class C and E Unit Forward Sale Agreement formula calculated the accretion of interest on $1.475 billion at
a fixed rate of 4.43 percent (composed of a swap rate of 4.18 percent plus a credit spread of 25 basis points), adjusted for
the cumulative future value of Barclays' monthly Bx payments to BB & T. James, Tr. 3798; JX 23 at 476; JX 36 at 721.
However, the parties never intended for this fixed interest rate to be paid. Cragg, Tr. 4573-74; Demo. Exs. 155, 156. Instead,
the parties simultaneously entered into a Zero Coupon Swap, which Dr. Cragg concluded has the effect of eliminating the
accretion payment, by exactly offsetting it. Id. As a result, the fixed rate accretion under the Class C and E Unit Forward
Sale Agreement had no economic effect. Cragg, Tr. 4573-75; Demo. Exs. 155-157; JX 36 at 725.
Because InvestCo paid the D Unit interest currently over the life of the STARS transaction, the forward sale price for that
Unit was simply $25 million, the same as the initial acquisition price. JX 24 at 491. The forward sale payments for the C, D,
and E Units were due at termination, when Barclays was to transfer the units to InvestCo. JX 23 at 470, 472, 486-87. Although
the Forward Sale Agreement for the C and E Units could have applied a variable rate of interest or scheduled the interest
payments to be paid monthly, it did not. The parties simply did not need a swap to convert the forward sale's fixed interest rate
to a variable interest rate. Kawaller, Tr. 4882. Rather, the parties used a simultaneously executed interest rate swap to set the
actual interest rate to be paid each month at LIBOR + 25 basis points on $1.475 billion. Kawaller, Tr. 4884-85; Demo. Ex. 8.
However, Barclays needed the fixed-payment accruing interest of the forward sale to make it appear that Barclays would suffer
a predictable U.K. tax loss by its purported equity investments in the Trust's E Unit, which by design, did not return anything
of value to Barclays. Monger, Tr. 649-50; Watson, Tr. 3546. Over the course of the transaction, Barclays would thus realize a
U.K. tax loss because of how it priced the forward sale, namely that it had to increase the value of its investment in the Class
E Unit of the Trust but had to sell back the Class E Units at a fixed price. Sultan, Dep. 52. Under U.K. tax law, Barclays was
able to deduct this anticipated future loss. Monger, Tr. 649-50; Zailer, Tr. 2665-66; Demo. Ex. 2; USX 2215 at 20.
Under a typical interest rate swap, two parties agree to exchange payments, each calculated with *152 reference to the same
principal amount. Kawaller, Tr. 4876-77; Demo. Ex. 5. One party to the interest rate swap agrees to pay a variable rate on the
principal amount, and the other party agrees to pay a fixed rate. Id. These two payment obligations are offset against each other,
and the net difference is paid by one party or the other. Kawaller, Tr. 4878; JX 281 at 3903.
BB & T and Barclays entered into an interest rate swap agreement simultaneously with the forward sale agreements, known
as the Zero Coupon Swap. JX 20; JX 23; JX 24. By this swap agreement, the parties replaced the lump sum accretion amount
due at termination on the C and E Units into a series of monthly payments computed at a variable interest rate based upon
LIBOR. Cragg, Tr. 4567; Demo. Ex. 147; JX 281 at 3903.
The fixed leg of the Zero Coupon Swap required Barclays to pay BB & T the net of (a) the accrued interest for the term of
the STARS transaction, using a fixed rate of 4.43 percent on $1.475 billion, and (b) the cumulative future value of Barclays'
monthly Bx payments to BB & T. Lys, Tr. 4217; JX 20 at 430; JX 36. This amount precisely equaled the accretion amount
that InvestCo was obligated to pay Barclays under the Forward Sale Agreement in connection with the C and E Units. JX 23 at
476. As a result, Barclays' fixed rate accretion amount obligation under the Zero Coupon Swap cancelled out InvestCo's fixed
rate accretion amount obligation under the C and E Unit Forward Sale Agreement, effectively negating the fixed interest rate
component of the Forward Sale Agreement. Cragg, Tr. 4573-74; Demo. Ex. 155; JX 36 at 725.
Because the fixed rate accretion in the Forward Sale Agreement and the Zero Coupon Swap were designed to cancel each
other *573 out, the choice of 4.18 percent plus 25 basis points as the rate to be included in both of these agreements had no
commercial importance and was entirely arbitrary. Finard, Tr. 5048-49; USX 1479; USX 771. The parties could have specified
any number at all in place of the 4.18 percent, and the economics of STARS would not have changed. Finard, Tr. 5048-49.
In addition, under the Zero Coupon Swap, InvestCo agreed to make monthly payments to Barclays on the same principal
sum of $1.475 billion at the variable rate of LIBOR + 25 basis points. Cragg, Tr. 4575; JX 20 at 432. The cumulative effect was
to replace InvestCo's fixed interest obligation under the Forward Sale Agreement with a variable interest obligation payable
monthly. Cragg, Tr. 4573-74; Demo. Ex. 155; JX 283 at 3903. Thus, the net effect of combining the Forward Sale Agreement
with the Zero Coupon Swap was that InvestCo paid Barclays interest at LIBOR + 25 basis points on $1.475 billion. Cragg,
Tr. 4573-74; Demo. Ex. 155.
Evaluating the net economic effect of the Loan therefore requires piecing together three agreements: (1) the Class C, D, and
E Unit Subscription Agreement, under which Barclays paid the Trust $1.475 billion for the C and E Units; (2) the Class C and E
Unit Forward Sale Agreements under which InvestCo committed to purchase those units at termination for $1.475 billion plus
an interest component of 4.43 percent each year; and (3) the Zero Coupon Swap, under which Barclays agreed to pay identically
computed interest at 4.43 percent each year, and InvestCo agreed to pay monthly interest at LIBOR + 25 basis points. Kawaller,
Tr. 4884-85; Demo. Ex. 8; James, Tr. 3798; JX 2 at 8-11; JX 20; JX 23 at 476; JX 36 at 721; JX 38.
With the offsetting fixed-rate interest payments under the Zero Coupon Swap and the Forward Sale Agreement netting out
to zero, and the remaining monthly interest payments by InvestCo to Barclays at LIBOR plus 25 basis points, the net effect of
this structure's three agreements was that BB & T received $1.475 billion from Barclays at an interest rate of LIBOR + 25 basis
points. Kawaller, Tr. 4893-94; JX 20; Finard, Tr. 5047-48; Demo. Ex. 27.
*153 5. Bx Payments From Barclays to BB & T
The Bx payment was the monthly payment that Barclays made to BB & T as part of the STARS transaction and constituted
one of the key components of the transaction. The monthly Bx payments were listed in a schedule in the Amended and Restated
Formulae Letter. JX 36 at 721-22; Cragg, Tr. 4513-14; Demo. Ex. 96. The Formulae Letter set forth the agreed interpretation
of how the formulas would operate in the Forward Sale, Zero Coupon Swap and Trust Agreements. JX 36 at 718-19. The
Formulae Letter contained the mathematical equation used to calculate the monthly Bx payments. JX 36 at 724; Cragg, Tr.
4514; Demo. Ex. 97.
The June 2002 draft Formulae Letter stated: BB & T's portion of the benefits under the transaction for each month (Bx in
the Forward Sale and Zero Coupon Swap formulas) will be calculated before the Closing Date by the formula below, which
references the specific Bx formula used in the BB & T STARS transaction. Cragg, Tr. 4516; JX 690 at 1398. As noted, it
was important for the parties to fix the monthly Bx payments before closing to avoid potential withholding tax on the interest
payments under the Zero Coupon Swap and the U.S./U.K. Double Taxation Treaty. Cragg, Tr. 4516-17; Demo. Ex. 101; USX
690 at 13.
The Bx payment formula was directly related to the amount of U.K. taxes paid by the Trust. From an economic perspective,
the amount of the Bx monthly payment constituted a rebate of the U.K. taxes paid by the Trust. Cragg, Tr. 4517; Demo. Ex.
103. Barclays described the monthly Bx payments as a percentage of the U.K. taxes. In a February 16, 2002 memorandum to
BB & T, Barclays' Mr. Sultan highlighted that the benefits from STARS were equal to 50 percent of the U.K. taxes. Mr. Sultan
stated: The benefit under STARS arises from the ability of both parties to obtain credits for the taxes paid in the trust. Thus,
the benefits to both BB & T and Barclays are easy to calculate and are equal to 50 percent of these taxes for each party. JX
244 at 16419; Cragg, Tr. 4519-20; Demo. Ex. 105. KPMG also described the monthly Bx payments as a *574 percentage of
the U.K. taxes. In a January 2002 KPMG presentation to BB & T, KPMG emphasized that BB & T obtains [a] rate reduction
of 50 percent of UK tax, or $27 million. Cragg, Tr. 4520; Demo. Ex. 106; JX 239 at 11266.
The Formulae Letter defined the monthly Bx payments as a percentage of the U.K. taxes. This letter stated: In words, Bx is
equal to 51 percent of the tax credits received by Barclays on the Class C Unit.... The Class C Unit constituted virtually all of
the Trust's income. Cragg, Tr. 4520-21; Demo. Ex. 107; JX 36 at 724. Barclays referred to the monthly Bx payments as both
a percent of the U.K. taxes and as a percent of Barclays' U.K. tax credit generated from the STARS transaction. Barclays used
these terms interchangeably. Cragg, Tr. 4526; Demo. Ex. 109; JX 244 at 16419-20. KPMG also used the terms interchangeably.
JX 239 at 11254.
The floating rate spread amounts in the Zero Coupon Swap were precisely the same values identified as the Bx in the
Formulae Letter. The parties to the transaction used Bx and floating rate spread amount to describe the same cash flows.
Cragg, Tr. 4584-86; Demo. Exs. 165, 166; JX 36 at 726.
Significantly, the Bx payments have no relationship to the amount of the Loan in the parties' modeling of the STARS
transaction. Cragg, Tr. 4589-90, 4592-93; Finard, Tr. 5098-99; Demo. Ex. 65, 66; Ioannidis, Dep. 184. Barclays created a
spreadsheet for the STARS model, and shared it with BB & T and other STARS' counterparties. Finard, Tr. 5086-87. The STARS
model for the BB & T transaction had built-in parameters to allow the parties to explore the impact of different relationships
using four specific variables, which included the amount of the Loan. Finard, Tr. 5088-99; Demo. Ex. 57-66. The model also
included a variable for the Bx payments. Id. The model permitted the parties to make projections of *154 cash flows and to
perform other calculations. Id. Application of the model demonstrated that when the amount of the STARS Loan was increased
or lowered, there were no changes to the amounts of the monthly Bx payments, confirming that there was no relationship
between the monthly Bx payments and the size of the STARS Loan. Cragg, Tr. 4590-93; Finard, Tr. 5088-99; Demo. Exs.
57-66. The amount of the Bx payment was determined solely by the amount of income that flowed through the Trust, which
had no relation to the amount of the Loan. Cragg, Tr. 4593-94; Demo. Ex. 170; USX 1545 at 14. The Bx amount was calculated
from a formula, which did not contain any mathematical term or symbol representing the STARS Loan. Cragg, Tr. 4595-96;
Demo. Ex. 171; JX 36 at 724. The Loan had no connection with the Bx. Cragg, Tr. 4595-96.
6. U.K. Tax and Accounting Treatment
The U.K. tax treatment of the STARS transaction is highly complex, but results in substantial benefit to Barclays, BB &
T, and the U.K. taxing authority, HMRC, all at the expense of the United States Treasury. At trial, the parties employed an
example based upon the existence of $100 of Trust income.
Under section 469 ICTA [FN8] 1988, the Trustee paid income tax to HMRC at 22 percent, or $22 of the $100 Trust income,
leaving the Trustee with $78 after the payment of U.K. income tax. Zailer, Tr. 2663-72. Under the same section, Barclays was
treated as receiving a Trust distribution of $78, but the amount was grossed up for the U.K. income tax of $22 so that Barclays
received a distribution of $100 and a tax credit of $22. Id. Because Barclays paid corporate tax at 30 percent, Barclays had to
pay only $8 in tax, which is the difference between its corporate tax liability of $30, less the tax credit of $22. Id.
The Trustee distributed the after-tax amount of $78 to Barclays, and Barclays recontributed the $78 back to the Trust. Id.
Barclays then claimed a $78 tax deduction, which at a 30 percent tax rate, yielded a $23.40 tax benefit. Id. Barclays' tax liability
of $8 could be eliminated using the $23.40 tax benefit from the deduction, leaving Barclays with a total tax benefit of $15.40
($23.40 minus $8). Id. Under Barclays' agreement with BB & T, Barclays had to rebate to BB & T a portion of the $22 tax
credit. Id. In *575 marketing STARS to BB & T, the Barclays and KPMG promoters showed the rebate payment as 50 percent,
or $11, although the parties ultimately agreed to a 51 percent rebate. PX 17 at 11223; USX 343 at 17; JX 36 at 724. Barclays
deducted the $11 rebate payment, which, at a 30 percent corporate tax rate, yielded $3.30. The total tax benefit to Barclays was
$18.70 ($3.30 plus $15.40). In economic terms, the benefit to Barclays was the U.K. tax benefit of $18.70, less the $11 rebate
to BB & T, or a total of $7.70. Peacock, Tr.
2205-06. The percentage split between Barclays and BB & T is contained in the Formulae Letter, where the Bx payment is
described as 51 percent of the $22 tax credit. JX 36.
The Trustee paid HMRC $22 in taxes, but because Barclays obtained an $18.70 U.K. tax benefit, the total tax collected by
HMRC was $3.30 ($22 less $18.70). Zailer, Tr. 2700-02. Barclays itself did not pay U.K. tax as part of the STARS structure. Id.
The U.K. tax treatment above makes the following assumptions: (1) that the STARS Trust is an unauthorized unit trust whose
Trustee is a U.K. resident for tax purposes; (2) that it is correct as a matter of U.K. law to treat Barclays as the holder of the
Class C Unit; (3) that it is correct as a matter of U.K. law to treat Barclays as the recipient of the Class C Unit distributions;
and (4) that Barclays was entitled to claim a tax deduction for the re-contribution of $78 to the Trust. Peacock, Tr. 2187-96.
Barclays assumed some risk that the HMRC *155 would challenge the above assumptions, and if challenged, there was a
risk that the challenge would be successful. Zailer, Tr. 2691-94; Demo. Ex. 9, 10. A successful challenge would invalidate the
intended STARS tax treatment, and Barclays' expected U.K. tax benefits under STARS. Zailer, Tr. 2691-92; Demo. Ex. 9.
7. Transaction Features Designed to Minimize Barclays' Economic Risks
The Class C and Class E Unit Forward Sale Agreement contained a make-whole feature under which BB & T was obligated
to reimburse Barclays if the credits generated by the Trust failed to match the parties' expectations. Peacock, Tr. 2212; JX 23
at 472, 480; JX 36 at 840. This provision provided safety to Barclays if there was less than full payment of U.K. taxes by the
Trust: ... this payment compensates Barclays if the Class C Unit distributions out of the trust (and hence the tax credits) are
less than the agreed level. Cragg, Tr. 4530-31; JX 36 at 841. The make-whole payment would only be made to Barclays on
the Class C and Class E Forward Sale Date, and therefore the makewhole payment also compensated Barclays for the time
value of money. JX 236.
If BB & T became obligated to reimburse Barclays under the make-whole provision, it would be making a direct payment
to Barclays rather than a tax payment to the United Kingdom. Cragg, Tr. 4533-34; JX 36 at 840-41. In this circumstance, BB
& T would be unable to claim foreign tax credits for the payment. Cragg, Tr. 4534-35. BB & T had an economic incentive to
ensure full and timely payment of U.K. tax on the Trust income. Id.
The Amended and Restated Participation Agreement contained an indemnity provision that would be triggered if the Trust
paid no tax because it was not a collective investment scheme, or if the Trustee was not a U.K. resident. Cragg, Tr. 4543-44;
JX 17 at 297. BB & T's indemnity payment to Barclays would be approximately one-half of the U.K. tax that the Trust would
have paid. Cragg, Tr. 4545; JX 17 at 298-99.
The parties also negotiated at-will termination rights. Johnson, Tr. 282-83; JX 23 at 472-73. Under the Forward Sale
Agreement, Barclays could terminate STARS for any reason with 30 days' notice. JX 23 at 473. If Barclays did not receive its
anticipated tax benefits, it could have terminated the transaction. USX 2219 at 14. BB & T also could terminate STARS for
any reason with 30 days' notice. JX 23 at 472-73. BB & T was well aware of this 30-day termination right. Monger, Tr. 1063;
Watson, Tr. 2867-68. BB & T wanted sufficient time to replace the STARS Loan if it became necessary. Monger, Tr. 730.
*576 8. Trust Income
Every month during the STARS transaction, BB & T targeted a pre-determined amount of money that it would briefly and
nominally transfer to Barclays. JX 23 at 478-80; USX 1972. These transfers were to occur on the fifteenth day of each month.
Over the expected 60-month duration, the pre-determined monthly transfers averaged $31,332,400. Id. As noted, the amounts
varied from month to month because of variations in the number of days per month and compounding asset income in the
transaction. Cragg, Tr. 4473-74. BB & T transferred these amounts, known as the Class C Unit distributions, to the Barclays
Blocked Account. Monger, Tr. 653-54; Coffield, Tr. 4414; USX 1972, rows 253, 257; USX 1994 at 2. A BB & T employee
would make these Class C Unit distributions, and at the same time, would make another equal and opposite transfer from the
Barclays' Blocked Account back to the original account. Coffield, Tr. 4427; USX 1972, rows 250, 253, 256-57. This latter
transfer was known as the E Unit reinvestment. Wild, Tr. 2625; USX 1972, rows 296-97.
The C Unit distribution amounts came from loan income held by BB & T's DelCo entity, known as Branch Finance LLC.
Coffield, Tr. 4398-99, 4412-13. A BB & T employee reviewed the pre-determined *156 Class C Unit distribution amounts
monthly and calculated how much money to transfer from DelCo to make the distribution. Coffield, Tr. 4414; USX 1988. These
distributions involved a simple chronological pattern:
* A payment from DelCo to the Trust;
* A payment from the Trust to the blocked account;
* A payment from the blocked account back to the Trust; and
* A payment from the Trust back to DelCo.
Monger, Tr. 1007-08. Logistically, all of these transfers took place during the same overnight process every month. Coffield,
Tr. 4430.
The purpose of exactly matching transfers to and from the blocked account was to create a trading loss for Barclays on its
U.K. taxes. Peacock, Tr. 2196; Wild, Tr. 2539-41. The transfers made it appear that Barclays received STARS Trust income by
the initial transfer to the blocked account, but then Barclays immediately and mandatorily reinvested the distributed amount
into the Class E Unit. Barclays then lost the reinvested contributions because it had to sell the E Unit back to BB & T for
an amount equal to its initial capital contribution. Peacock, Tr. 2196; Sultan, Dep. 106-07. Barclays had no economic interest
in the Class C Unit distributions and never intended to receive any benefits from these distributions aside from tax benefits.
Sultan, Dep. 122, 263; Abrahams, Dep. 48. Nevertheless, Barclays took the position that U.K. tax law would respect the Class
C Unit ownership because of the law's alleged recognition of form over substance. Sultan, Dep. 122-23.
DelCo held the assets used in STARS, rather than the Trust, for U.K. tax reasons. Wilkerson, Tr. 1808-09. If the Trust had
held the STARS assets, it might have exposed the assets to U.K. capital gains taxes and foreign currency gains taxes, neither of
which would have produced a benefit for Barclays within the STARS structure. Wilkerson, Tr. 1808-09; Lys, Tr. 4060. Further,
BB & T would have been required to reimburse Barclays for any U.K. tax that Barclays incurred on capital gains arising in
the Trust. USX 2215 at 54-56. BB & T also recognized that it might not be able to claim foreign tax credits for any payment
of a capital gains tax paid by the Trust. Id.
In order to ensure that DelCo maintained a large enough pool of assets to make the monthly payment of the dividend on the
Branch Finance Class II Shares, BB & T employees monitored the Loan assets in DelCo on a daily basis. Coffield, Tr. 4397-98,
4401. For example, if DelCo auto loans were paid off or otherwise retired, new assets had to be transferred to DelCo to maintain
the necessary income levels. Coffield, Tr. 4398-400; Finard, Tr. 5119. This exercise involved determining what assets DelCo
could purchase from the main BB & T North Carolina entity, and then internally selling those Loan assets from BB & T North
Carolina to DelCo as necessary. Coffield, Tr. 4399-400.
*577 9. STARS Submission to the North Carolina Commissioner of Banks
In the spring of 2002, BB & T informed the North Carolina Commissioner of Banks (NCCOB) of the STARS transaction.
Hudson, Tr. 1565; JX 258; JX 268. The NCCOB is the public regulator of North Carolina state-chartered banks. The NCCOB
is responsible for ensuring that North Carolina is served by banks that are able to meet the credit needs and other financial
services of those within the state. Smith, Tr. 2950. A fundamental element of this responsibility is reviewing the safety and
soundness of regulated banks, which consists of assessing a bank's capital, asset quality, management, earnings, liquidity, and
sensitivity to interest-rate risk. Smith, Tr. 2906-07. The NCCOB does not assist North Carolina chartered banks in complying
with federal tax law. Smith, Tr. *157 2950. The NCCOB staff is not trained in federal tax law. Smith, Tr. 2920-22, 2952-53.
BB & T sought from the NCCOB a non-objection letter regarding STARS in order to secure the NCCOB's determination that
the STARS entities would be considered operating subsidiaries under North Carolina law. Smith, Tr. 2928-29. BB & T's purpose
essentially was to obtain the NCCOB's permission to form the STARS entities. Hudson, Tr. 1565-66. If BB & T had not taken
this step, and if the NCCOB later had determined that, under North Carolina law, the STARS entities were subsidiaries engaged
in nonbanking activities, the consequences to BB & T would have been significant. Smith, Tr. 2967-68; Hudson, Tr. 1476.
BB & T's in-house counsel, Howard Hudson, sent the NCCOB a letter dated April 11, 2002 that discussed STARS as making
available to BB & T over the next five years cost effective funding of $1.5 billion at approximately 300 basis points below BB
& T's normal funding cost on an underlying asset pool of $7.2 billion. JX 258 at 1. This letter described STARS as somewhat
complex in nature, and BB & T offered to make Mr. Watson and Mr. Monger available to explain STARS to the NCCOB staff.
Id. BB & T intended to give the NCCOB a preliminary tutorial on STARS before formally seeking non-objection. Hudson,
Tr. 1476. In approaching the NCCOB, BB & T did not mention a sharing of U.K. tax benefits with Barclays, or that the low
financing was made possible by claiming foreign tax credits in the United States. Smith, Tr. 2954-58; JX 258.
On April 23, 2002, the NCCOB's Daniel Garner requested a conference call with BB & T, and asked that BB & T assume
they are talking to a college student taking an accounting class, and then walk[ing] [NCCOB] through it at that level. JX 263.
Shortly thereafter, BB & T executives met with Daniel Garner and others at NCCOB to provide them with an overall briefing
about STARS. Hudson, Tr. 1560. During the briefing, BB & T did not describe the C Unit distribution and the corresponding
E Unit recontribution as a circular cash flow. Smith, Tr. 2962-63. Before STARS, Mr. Smith had not heard of a financing
transaction with an interest rate of 300 basis points below LIBOR, and he never fully understood how Barclays was able to
offer below-LIBOR financing to BB & T via the STARS transaction. Smith, Tr. 2959, 2961.
By letter dated June 5, 2002, BB & T formally sought non-objection from the NCCOB regarding the STARS entities. JX 268.
In that letter, BB & T described STARS as a synthetic financing transaction under which BB & T will borrow approximately
$1.5 billion from Barclays.... The primary benefit of the Financing Transaction is that the interest rate payable by BB & T will
be at an effective rate of 290 basis points below BB & T's normal cost of funds.... Id. According to this letter, such a benefit
was predicated on interpretations of both United States and United Kingdom tax laws and regulations. Id.
On June 6, 2002, the NCCOB informally indicated to BB & T its non-objection to the STARS entities. USX 667. By letter
dated June 14, 2002, the NCCOB formally provided to BB & T such non-objection. JX 270. The NCCOB issued the formal
nonobjection letter with the understanding that BB & T would obtain opinion letters as outlined in the application ... and
attempt to insure *578 that the activities of ... the agents, employees, and affiliates ... that may be taken on behalf of the Bank
shall comply with all applicable federal, state, and local laws and regulations. Id. at 13509. The nonobjection letter also stated
it was not an endorsement of STARS, but rather, was merely a statement by NCCOB that the STARS entities did not appear
to pose a threat to BB & T's safety and soundness. Id.
The NCCOB never independently analyzed the tax treatment of BB & T's STARS transaction, and never sought a third-party
analysis for this purpose. *158 Smith, Tr. 2959-60. The NCCOB relied on BB & T's assurance in its formal request for non-
objection that BB & T would receive written tax opinions from both Sidley Austin and KPMG regarding STARS' tax effects.
Smith, Tr. 2960; JX 268. During his tenure as NCCOB Commissioner, Mr. Smith personally wanted BB & T to become the
largest state-chartered bank in the United States. Smith, Tr. 2948-50.
F. Possible Second STARS Transaction
Starting in June 2003, various newspaper stories were published regarding KPMG, Sidley Austin and Mr. Ruble, and their role
in allegedly improper tax shelters. See USX 1296; USX 1453; USX 1475. [FN9] On or about October 2003, Mr. Monger knew
that Sidley Austin had terminated Mr. Ruble, and discussed that fact with Messrs. Hudson and Reed. Monger, Tr. 1372-74. At
some time in 2003 or 2004, Mr. Watson and other executives at BB & T learned that KPMG, Mr. Ruble, and Sidley Austin were
all under scrutiny for tax shelter activity. Watson, Tr. 3553-55. Although KPMG and Sidley Austin were receiving negative
publicity regarding abusive tax shelters, Barclays pitched a second STARS transaction to BB & T. Watson, 3559-60.
By April 15, 2004, there was a pending IRS audit of BB & T's listed transactions from 1998-2002, which included STARS.
USX 1601. In an internal Barclays email sent that day, Mr. Ioannidis stated that Mr. Monger does not want to be expanding a
trade which is currently under IRS review. Id.; Monger, Tr. 1363-68; Watson, Tr. 3561-63. Despite this pending audit, in mid-
May 2004, BB & T was considering extending its STARS transaction. USX 1623. The following month, Barclays presented a
proposal to BB & T regarding Additional STARS Financing. USX 1623; Watson, Tr. 3558-60.
By August 2004, BB & T executives knew that Mr. Ruble and Sidley Austin were under investigation by the federal
government, and that Mr. Ruble had been represented in the media as blessing tax shelter products of KPMG. Monger, Tr.
1382-85. After learning this information, BB & T requested and received assurances from Sidley Austin that the law firm would
stand behind its STARS opinions. Id. at 1385-86.
Mr. Monger retired in October 2004, and Mr. Watson took over his position as STARS project director at BB & T. Watson,
Tr. 3576-77. On April 6, 2006, Mr. Watson attended a meeting of the Trustee's Board of Directors. USX 1855 at 2; Watson, Tr.
3579-81. At this meeting, Mr. Watson indicated to the directors that BB & T was interested in extending the STARS transaction.
USX 1855 at 2; Watson, Tr. 3579-81. On May 11, 2006, the managers of InvestCo held their annual meeting, at which they
adopted a resolution authorizing action to extend STARS. USX 1865; Watson, Tr. 3581-82.
Internal KPMG email correspondence dated May 18, 2006 discussed a potential extension of the STARS transaction with BB
& T. USX 1869; Watson, Tr. 3576-79. The email explained that [t]hey've [BB & T] been briefed about the potential impending
bad publicity and been advised to consider diversifying their risk by looking at other strategies and counterparts. They seem to
be undaunted and want to proceed. USX 1869. As late as June 15, 2006, BB & T was considering an extension of the STARS
*579 *159 transaction of up to five years. JX 272; USX 1879.
In November 2006, the IRS issued three Information Document Requests (IDRs) to BB & T related to the STARS
transaction and the entities used to implement it. USX 1908-10; Watson, Tr. 3584-86. The IRS issued three additional IDRs to
BB & T related to the STARS transaction in December 2006. USX 1923-25; Watson, Tr. 3586-88. In January 2007, a federal
court decided against BB & T in litigation involving BB & T's LILO transactions, which resulted in a significant tax impact to
BB & T. BB & T Corp. v. United States, 2007 WL 37798 (M.D.N.C.2007); Watson, Tr. 3588-89.
G. Termination of BB & T STARS
Mr. Watson recognized that BB & T may need to terminate STARS early, in the event of an IRS challenge to the transaction
or a change in U.S. or U.K. tax law. Watson, Tr. 3471. On March 30, 2007, the IRS published its proposed Regulations on
Transactions Designed to Artificially Generate Foreign Tax Credits. 72 FR 15081, REG-156779-06, March 30, 2007. Some
of KPMG's clients terminated STARS because of the effect of these proposed Treasury regulations on their ability to claim
foreign tax credits for the STARS transaction. Wilkerson, Tr. 1863.
BB & T terminated its STARS transaction as of April 5, 2007. Stip. 86; JX 168-171; JX 184; JX 193-201. Representatives
of BB & T testified at trial that BB & T terminated STARS because it believed a potential change in U.K. tax law might cause
Barclays to terminate STARS, and wanted to terminate it at a good time for us [BB & T] to get financing somewhere else in
the market. Allison, Tr. 825; Watson, Tr. 2867-70.
To terminate the STARS transaction, InvestCo purchased Barclays' C and E Units by paying Barclays $1,479,680,507.
InvestCo purchased Barclays' D Unit by paying $25,079,340. Stip. 87. Because the transaction was not terminated on a regular
monthly STARS payment date, InvestCo had to pay mid-month interest: an additional $4,680,507 over the principal amount for
the C and E Units, and an additional $79,340 over the principal amount for the D Unit. JX 36. Through these payments, InvestCo
repaid the principal amount of the STARS transaction financing. Stip. 88. The Asteras preferred shares remained outstanding
until June 15, 2007, at which time InvestCo redeemed the $65 million in preferred shares issued to Asteras. Stip. 89.
H. Costs and Fees of BB & T STARS
1. Third Party Fees
As discussed above, KPMG and BB & T negotiated and agreed to a fixed fee of $6.5 million, plus hourly assistance. JX 254.
Of that amount, $500,000 would be deferred for each of the five projected years of STARS. Monger, Tr. 1196; JX 254. Mr.
Monger also negotiated with KPMG that it would render a minimum amount of services for no fee in the event of an IRS audit
of the STARS transaction, not to exceed 350 hours. USX 470; Monger, Tr. 1156-1157; Watson, Tr. 3471-73, 3622-25; JX 254.
Fees for examination assistance in excess of 350 hours were to be billed at mutually agreeable rates. JX 264. The $6.5 million in
fees was by a significant margin the most that BB & T had ever paid for a tax solution. Monger, Tr. 1191; USX 2238 at 1-2.
Also as discussed above, BB & T retained the law firm of Sidley Austin to assist in tax matters. Monger, Tr. 1295; JX 243.
Sidley Austin was to receive a flat fee of $300,000 for tax matters, and monthly billing at the firm's standard rate for any
corporate law work. JX 243 at 3. BB & T paid a total of $1,355,929.91 to Sidley Austin for its various legal opinions and
other advice provided with the transaction. USX 679 at 1, 4; USX 937 at 1-3; USX 1115; USX 1587; USX 1966; USX 2096.
The total fees that BB & T paid to KPMG and Sidley Austin represented 52 or 53 basis points on the $1.5 billion financing.
Monger, Tr. 699.
*160 BB & T incurred fees for services rendered by PwC with respect to the STARS transaction from March 16, 2002
through May 15, 2003. BB & T paid PwC a total amount of $117,085. USX 591.
BB & T did not pay Barclays a direct fee for its participation in the transaction. LaRue, Tr. 5322.
*580 2. Internal Administrative Costs
BB & T executives and employees expended considerable time and resources reviewing and implementing STARS. Monger,
Tr. 602; Allison, Tr. 894. Once BB & T entered into the STARS transaction, the BB & T general accounting department
employed many steps to implement the transaction processes, some of which could take up to seven hours a day. Coffield,
Tr. 4397-440.
The STARS Trust structure also required expenditures within BB & T. USX 2212 at 54-55. The Trust structure required the
payment of administrative costs and fees, some of which would not have been incurred if not for the transaction. Id. at 54. Over
the life of the transaction, the Trust would have service fees of $2.2 million. Id. BB & T also anticipated costs for incremental
operating expenses, such as salaries, benefits & other expenses, as well as travel costs, amounting to $87,000 annually. USX
933 at 5; USX 2212 at 54. Additionally, special purpose entities created specifically for the transaction required management
fees possibly in excess of $2.6 million. USX 2211 at 16; USX 2212 at 54-55, 106, 116-117.
I. Expert Witnesses
Thirteen expert witnesses testified at trial, seven called by BB & T and six called by the Government. The expert witnesses
for BB & T were: (1) Mr. William Isaac, an expert in banking oversight and management; (2) Dr. Christopher James, an expert
in banking and finance; (3) Dr. Thomas Lys, an expert in economics; (4) Mr. David Rosenbloom, an expert in international tax;
(5) Mr. Jonathan Peacock, an expert in U.K. tax law; (6) Mr. Martin Brooks, an expert in U.K. tax administration; and (7) Mr.
Kenneth Wild, an expert in U.K. accounting. The Government's experts were: (1) Dr. Michael Cragg, an expert in economics
and financial analysis; (2) Mr. Joel Finard, an expert in capital market analysis and structured finance analysis; (3) Dr. Ira
Kawaller, an expert in economics and the use of derivative contracts; (4) Dr. David LaRue, an expert in economics, accounting
and tax compliance; (5) Mr. Isaac Zailer, an expert in U.K. tax law; and (6) Mr. Michael Taub, an expert in U.K. accounting.
While all of the experts were helpful to the Court in varying degrees, Dr. Cragg for the Government was the single most helpful
expert in providing a comprehensive analysis of the STARS transaction.
Dr. Cragg analyzed the source of benefits in the STARS transaction. He testified that the benefits of STARS arose solely from
artificially created U.K. taxes and foreign tax credits. He concluded that, as an economic matter, BB & T's voluntary action of
subjecting its U.S.-sourced income to a U.K. tax was the source of the financial benefits to both BB & T and Barclays from
STARS. Cragg, Tr. 4548-52. He noted that in return for BB & T circulating its income through a Delaware trust with a U.K.
trustee, which subjected the income to a U.K. tax, Barclays agreed to make monthly payments labeled as the Bx to BB &
T. Id. at 4463. The Bx payment represented a return or rebate by Barclays of 51 percent of the U.K. tax paid by BB & T. Id.
at 4517; Demo. Ex. 103. By voluntarily paying U.K. taxes on U.S.-sourced income, BB & T was thereby able to claim U.S.
foreign tax credits. Cragg, Tr. 4548-52.
Dr. Cragg also testified that the Bx payment was purely a tax effect and could not be considered a component of interest. Id.
at 4583-84, 4601. His economic analysis showed that the netting of the Bx payments from Barclays with the monthly interest
payments on the Loan resulted in an interest rate of approximately 300 basis points below LIBOR. Id. at 4588-89; Demo. Ex.
168. He observed that the netting *161 of these two payment obligations could be expected to result in a negative interest
rate owed by BB & T. Cragg, Tr. 4632; USX 2212 at 60-62. For the first 35 months of the Loan, the lender, Barclays, was
paying the borrower, BB & T, to borrow its funds. Dr. Kawaller testified that it makes no economic sense for a lender to pay
a borrower. Kawaller, Tr. 4632.
Dr. Cragg also demonstrated that the STARS Trust structure consisted of a series of economically meaningless circular cash
flows, and that the STARS Trust was separable from the Loan and had no economic purpose. Cragg, Tr. 4493-94, 4658; Demo.
Exs. 215-220. He showed that the Trust *581 was artificially combined with the Loan, which, excluding the U.S. tax benefits
derived from STARS, was high-cost relative to BB & T's alternative funding opportunities. Cragg, Tr. 4646-48; Demo. Ex.
205-206. According to Dr. Cragg, neither the Loan, nor the Trust, nor the combination of the two offered any possibility of non-
tax profit for BB & T. Cragg, Tr. 4648-49, 4610, 4671-72; Demo. Exs. 179, 181, 208. Dr. Cragg demonstrated that ultimately
the sole purpose of STARS was to transfer more than $400 million from the U.S. Treasury to BB & T, Barclays, and the U.K.
tax authority. Cragg, Tr. 4680; Demo. Ex. 230.
Mr. Finard testified that BB & T's stated business purposes for the STARS transaction were not consistent with the
transaction's financial risks and rewards. Mr. Finard's capital markets analysis showed that STARS was not low-cost funding
and that it did not provide liquidity risk management benefits. Finard, Tr. 5125, 5141; Demo. Ex. 80, 91. Mr. Finard concluded
that, once stripped of its needless complexity, STARS consisted of two, simple unrelated transactions--the Loan and the Trust.
The two components were artificially linked to enable BB & T to deduct U.S. tax benefits generated by the Trust structure
from the cost of the Loan, thereby making the Loan appear to be low-cost funding. Finard, Tr. 5038-39, 5081-82, 5146-48;
Demo. Ex. 19-21, 97-98.
Dr. Kawaller's analysis of the cash flows of STARS demonstrated that the Bx payments were a rebate of taxes, not an interest
expense, and should not be considered in a pre-tax profitability analysis. Kawaller, Tr. 4898-900. He established that when the
Bx payments were excluded, the STARS transaction was not profitable for BB & T. Id. at 4924-25.
Like Mr. Finard, Dr. LaRue determined that, from an economic and analytical perspective, the STARS transaction consisted
of two functionally unrelated and discrete components, the Trust and the Loan. LaRue, Tr. 5286; Demo. Ex. 3-5. Dr. LaRue's
analysis of the Trust structure demonstrated that the Trust was not intrinsically capable of generating any pre-tax economic
profit. Although BB & T incurred substantial transaction costs in establishing the Trust, the only economic benefits were from
the tax rebates. LaRue, Tr. 5306-08; Demo. Ex. 16-17.
Mr. Zailer testified about the risk that the U.K. tax authority would challenge the STARS transaction. Zailer, Tr. 2694. He
observed that HMRC would most likely challenge a transaction when it loses money, not where it gains revenue, such as in
STARS. Id. at 2725-29. Barclays' correspondence with HMRC was misleading because it suggested that Barclays was paying
the extra tax. In fact, the extra revenue to HMRC was a residual payment from the Trustee. Id. at 2701-02.
Mr. Taub's analysis demonstrated that Barclays was not in compliance with U.K. Generally Accepted Accounting Principles
(GAAP) in its financial reporting of STARS. In particular, Barclays inappropriately accounted for the income on the monthly
C Unit distributions because the funds were simply part of a circular flow of funds having no economic reality. Taub, Tr.
2591-92, 2606; Demo. Ex. 10-11, 21; USX 2214 at 9.
Among Plaintiff's experts, Dr. Lys testified that *162 STARS generated pre-tax profit for BB & T based on the assumption
that the assets purchased by BB & T with the STARS proceeds were incremental. Lys, Tr. 4110-11. However, BB & T would
have borrowed from other sources in the absence of STARS. Dr. Lys calculates the profitability of STARS as the return on
the Loan proceeds, id. at 4109-11, but this testimony overlooks that BB & T would have had loan proceeds from any loan.
This fact alone cannot provide a non-tax business purpose for the STARS transaction. The testimony of Dr. James suffers from
the same shortcoming. James, Tr. 3633-36.
Mr. Isaac viewed STARS as low-cost funding that was strategically important to BB & T because it improved the bank's
liquidity, provided greater loan diversity through international funding, and helped to fund the bank's asset growth. Isaac, Tr.
3256-57. However, the evidentiary record does not contain a single contemporaneous reference to these purported benefits
except for the *582 low-cost funding. Id. at 3390-91. Indeed, the record reflects that BB & T could have borrowed from other
sources, such as the Federal Home Loan Bank Board (FHLB), at favorable loan rates. The unusually low financing created
under STARS is made possible purely by the rebate of U.K. taxes. The Court commends Plaintiff's experts for their ingenuity,
but no matter how one holds the STARS prism to the light, the benefits are driven solely by the sham circular cash flows of
the Trust.
II. Discussion
A. Standards for Decision
[1]A tax refund suit is a de novo proceeding, not an appellate review of the administrative decision that was made by the
IRS[.] Wells Fargo & Co. v. United States, 91 Fed.Cl. 35, 75 (2010) (quoting D'Avanzo v. United States, 54 Fed.Cl. 183,
186 (2002)), aff'd, 641 F.3d 1319 (Fed. Cir.2011). Thus, in conducting its de novo review, the Court gives no weight ... to
subsidiary factual findings made by the [IRS] in its internal administrative proceedings. Id. (quoting Cook v. United States,
46 Fed.Cl. 110, 113 (2000)).
[2][3]In addition, the plaintiff in a tax refund suit bears the burden of proving that it has overpaid its taxes for the year in
question in the exact amount of the refund sought. Id. (citing, inter alia, Lewis v. Reynolds, 284 U.S. 281, 52 S.Ct. 145, 76
L.Ed. 293 (1932); Dysart v. United States, 169 Ct.Cl. 276, 340 F.2d 624 (1965)). This burden includes both the burden of
going forward and the burden of persuasion, Sara Lee Corp. v. United States, 29 Fed.Cl. 330, 334 (1993), and must be met by
a preponderance of the evidence, Ebert v. United States, 66 Fed.Cl. 287, 291 (2005). Accordingly, in order to fully or partially
prevail in this suit, Plaintiff must demonstrate, by a preponderance of the evidence, its entitlement to the specific amount of
the tax refund at issue.
B. Treatment of U.S. Foreign Tax Credits
The United States taxes the income of its citizens, residents, and domestic entities on a worldwide basis--i.e., regardless of
whether the income is earned domestically or internationally. Thus, a domestic corporation must include foreign source income
on its U.S. tax returns even though that income may also have been subject to foreign taxation. Since 1918, however, the United
States has allowed domestic taxpayers in this circumstance to claim a dollar-for-dollar credit in the U.S. for income taxes they
have paid in a foreign country. Revenue Act of 1918, Pub.L. No. 65-245, 238(a), 40 Stat. 1057, 1080-81; current codification
at 26 U.S.C. 27, 901.
[4]As courts consistently have recognized, the purpose of the foreign tax credit is to allow taxpayers to avoid double taxation
on foreign income, and thus to neutralize the effect of U.S. tax on the business decision of where to conduct business activities
most productively. Bank of New York, 140 T.C. at 46; see also United States v. Goodyear Tire & Rubber Co., 493 U.S. 132,
139, 110 S.Ct. 462, 107 L.Ed.2d 449 (1989) (noting that the history of the credit clearly demonstrates that it was intended to
eliminate double *163 taxation); Am. Chicle Co. v. United States, 316 U.S. 450, 451, 62 S.Ct. 1144, 86 L.Ed. 1591 (1942);
Burnet v. Chicago Portrait Co., 285 U.S. 1, 7, 52 S.Ct. 275, 76 L.Ed. 587 (1932); Guardian Indus. Corp. v. United States, 477
F.3d 1368, 1374 (Fed.Cir.2007); 56 Cong. Rec. App. 677-78 (1918) (statement of Rep. Kitchin); Joint Committee on Taxation,
The Impact of International Tax Reform: Background and Selected Issues Relating to U.S. International Tax Rules and the
Competitiveness of U.S. Businesses (JCX-22-06) (noting that [a] resident has no incentive under a worldwide [tax] system
either to move activities abroad or to keep them within the residence country.... Thus, investment-location decisions [by U.S.
citizens, residents, and corporations] are governed by business considerations, instead of by tax law.).
[5][6]The purpose of the foreign tax credit is to permit substantive business decisions to be made largely independent of the
tax consequences of the United States' worldwide system of taxation. Accordingly, it is well established that a taxpayer may
structure its business transactions so as to minimize its tax liability. *583Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.1934)
(Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will
best pay the Treasury; there is not even a patriotic duty to increase one's taxes.) (Learned Hand, J.), aff'd, Gregory v. Helvering,
293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935); Boulware v. United States, 552 U.S. 421, 429 n.7, 128 S.Ct. 1168, 170 L.Ed.2d
34 (2008). Balancing this principle is the recognition that even if a transaction complies literally with the provisions of the
Internal Revenue Code, it does not necessarily follow that Congress intended to cover every foreign transaction and allow a
tax benefit. Bank of New York, 140 T.C. at 31 (citing, inter alia, Knetsch v. United States, 364 U.S. 361, 365, 81 S.Ct. 132, 5
L.Ed.2d 128 (1960)). Instead, the determinative question when assessing whether a party is entitled to particular tax benefit is
whether what was done, apart from the tax motive, was the thing which the statute [creating the benefit] intended. Knetsch,
364 U.S. at 365, 81 S.Ct. 132 (quoting Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 79 L.Ed. 596 (1935)). This
substance-based analysis has spawned various judicial doctrines, such as the economic substance doctrine, that prevent the
recognition of benefits from abusive tax shelters.
[7][8]The economic substance doctrine provides that technical compliance with the tax code notwithstanding, a taxpayer
bears the burden of demonstrating that a given transaction carries both (1) the objective possibility of realizing a pre-tax profit
(objective economic substance), and (2) a non-tax business purpose (subjective economic substance). Wells Fargo, 91 Fed.Cl.
at 81 (citing Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed. Cir.2006)); Stobie Creek Investments LLC v.
United States, 608 F.3d 1366, 1375 (Fed.Cir.2010). This doctrine seeks to distinguish between structuring a real transaction
in a particular way to obtain a tax benefit, which is legitimate, and creating a transaction to generate a tax benefit, which is
illegitimate. Stobie Creek, 608 F.3d at 1375 (internal citations omitted) (emphasis in original).
[9][10]In ASA Investerings Partnership v. Commissioner of Internal Revenue, 201 F.3d 505 (D.C.Cir.2000), the D.C. Circuit
eloquently described the requirement for a non-tax business purpose:
It is uniformly recognized that taxpayers are entitled to structure their transactions in such a way as to minimize tax. When
the business purpose doctrine is violated, such structuring is deemed to have gotten out of hand, to have been carried to
such extreme lengths that the business purpose is no more than a facade. But there is no absolutely clear line between the
two. Yet the doctrine seems essential. A tax system of rather high rates gives a multitude of clever individuals in the private
sector powerful incentives to game the system. Even the smartest drafters of legislation and regulation cannot be expected
*164 to anticipate every device. The business purpose doctrine reduces the incentive to engage in such essentially wasteful
activity, and in addition helps achieve reasonable equity among taxpayers who are similarly situated--in every respect except
for differing investments in tax avoidance.
ASA Investerings, 201 F.3d at 513.
[11]The economic substance doctrine applies in equal force to foreign tax credits. Courts have considered the specific issue
of whether the substance doctrines apply to the availability of foreign tax credits, and have ruled in the affirmative. [FN10]
Indeed, the Tax Court recently applied the economic substance doctrine to a similar STARS transaction between Barclays and
the Bank of New York. Emphasizing that the purpose of the foreign tax credit is to alleviate double taxation arising from
foreign business operations, the court in Bank of New York held that:
*584 [t]he STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law
inconsistencies. The U.K. taxes at issue did not arise from any substantive foreign activity. Indeed, they were produced though
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.
140 T.C. at 46-47. Similarly, the Southern District of New York also recently applied the economic substance doctrine to
disallow a claim for foreign tax credits in AIG:
Because Congress created the foreign tax credit for the taxpayer who desires to engage in purposive activity, and sought
only to eliminate the disadvantage to his foreign business imposed by U.S. taxation of worldwide income, it appears not to
have intended the credit be available to transactions that have no economic utility and that would not be engaged in but for
the system of taxes imposed by Congress simply because the transaction caused the taxpayer to pay foreign tax.
2013 WL 1286193, at * 4(citation omitted) (quoting Goldstein v. Comm'r, 364 F.2d 734, 741, 742 (2d Cir.1966)).
[12]The application of the economic substance doctrine to foreign tax credits is fully consonant with the purpose behind such
credits: to establish neutrality through the elimination of double taxation that would arise in the absence of foreign tax credits.
Thus, the requirements of the economic substance doctrine--namely, that a transaction be pre-tax profitable and have a non-
tax business purpose--are fully compatible with the foreign tax credit regime. See AIG, 2013 WL 1286193, at *3 (Congress
intended the [foreign tax] credit to facilitate purposive business transactions, not by subsidy, but by restoring the neutrality
of the tax system.); Pritired, 816 F.Supp.2d at 741 ([Foreign tax credits] are available to prevent double-taxation, not to
generate an enhanced return on the basis of structuring transactions to increase the available [foreign tax credits].) (emphasis
in original). Accordingly, there is no foreign tax credit exception to the economic substance doctrine.
C. Economic Substance of STARS
[13][14][15]As noted above, a taxpayer bears the *165 burden of proving that the challenged transaction had (1) objective
economic substance and (2) a non-tax business purpose. Wells Fargo, 91 Fed.Cl. at 81 (citing, inter alia, Coltec, 454 F.3d at
1355-56). The objective inquiry focuses on whether the transaction created a reasonable opportunity of making a profit from
the transaction. Coltec, 454 F.3d at 1356; Bank of New York, 140 T.C. at 34. The subjective, non-tax business purpose inquiry
focuses on whether the taxpayer's sole subjective motivation is tax avoidance, including whether the transaction is shaped
solely by tax-avoidance features. Coltec, 454 F.3d at 1355, 1355 n.13 (quoting Frank Lyon Co. v. United States, 435 U.S.
561, 583-84, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978)). The transaction to be analyzed is the one that gave rise to the alleged tax
benefit, id. at 1356, even if it is part of a larger set of transactions or steps, Bank of New York, 140 T.C. at 33 (citing, inter
alia, Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir.2002)). Stated another way, the requirements of the economic
substance doctrine are not avoided simply by coupling a routine transaction with a transaction lacking economic substance. A
contrary application would undermine the flexibility and efficacy of the economic substance doctrine. Id. (citation omitted);
see also Coltec, 454 F.3d at 1356 (observing that a taxpayer cannot show a non-tax business purpose simply by showing some
factual connection ... to an otherwise legitimate transaction) (quoting Basic Inc. v. United States, 212 Ct.Cl. 399, 409, 549
F.2d 740 (1977)).
[16][17]The first step in the economic substance inquiry is to identify the transaction to be analyzed. The Government urges
that the Trust and the Loan are economically distinct, and that as a matter of both law and economics, the Court should conduct
an analysis of the Trust as a stand-alone transaction. Plaintiff opposes this view, arguing that STARS must be analyzed as a
single, integrated transaction because the so called *585 components' ... were linked by the business and commercial realities
of the parties[.] Pl.'s Br. 217. The Court agrees with the Government that the links between the Trust and Loan components
of STARS are artificial, and further, that the disputed foreign tax credits are attributable solely to the Trust. Accordingly, the
Court will bifurcate the STARS transaction and examine the Trust structure for economic substance, independent of the Loan.
However, the Court also will apply the economic substance analysis through the lens of STARS as an integrated transaction. As
demonstrated below, the STARS transaction also lacks economic substance when the Trust and the Loan are examined together.
D. Bifurcated Analysis
1. The STARS Trust Structure
[18]The STARS Trust structure consisted of a number of newly created and one existing special purpose entities. BB & T
used the Trust structure to subject its income from assets in the United States to tax in the United Kingdom without otherwise
altering that income or its management and control of the assets. BB & T accomplished the U.K. tax effect by circulating
the income among the STARS entities, and into and out of a blocked account. The disputed foreign tax credits are entirely
attributable to the Trust structure and not to the Loan. The creation of the Trust and the circulation of income were not required
to activate a loan from Barclays to BB & T, and the existence of a loan was not required for the STARS Trust to generate the
tax credits at issue. In fact, the Court notes that STARS initially was designed to generate the same foreign tax credits without
any loan component. In the early iterations of STARS, the Bx payment served simply to enhance the revenue being earned on
the Trust assets. Peacock, Tr. 2309.
[19]The STARS Trust consisted of three principal circular cash flows. A circular cash flow is a set of offsetting cash entries
that lack economic importance. Courts have consistently recognized that the presence of circular cashflows strongly indicates
that a transaction lacks economic substance. Bank of New York, 140 T.C. at 36; see also Consol. Edison Co. v. United States,
703 F.3d 1367, 1375 (Fed.Cir.2013) ([W]e *166 easily concluded that the court was left with purely circular transactions
that elevate[d] form over substance.) (quoting Wells Fargo & Co. v. United States, 641 F.3d 1319, 1330 (Fed.Cir.2011)). It
hardly requires mention that no profit and no risk will occur in a circular cash flow. Wild, Tr. 2354. [FN11]
In the first circular cash flow, BB & T caused an entity called DelCo to make monthly distributions to the Trust which the
Trust immediately returned to DelCo. Cycling the income from DelCo to the Trust had the effect of subjecting the income to
U.K. tax without changing the substance or character of the income. In the second circular cash flow, BB & T cause the Trust
to deposit a predetermined amount into a blocked account, and then to withdraw that amount immediately. This circular cash
flow was necessary to allow Barclays to claim a U.K. tax loss for the purported reinvestment of the 99 percent portion of the
Trust's income. Barclays was nominally entitled to this amount, but the transaction had no economic effect. In the third circular
cash flow, BB & T cycled tax through the U.K. taxing authority, then to Barclays, and then back to itself. This cash flow also
was meaningless from an economic perspective. The final step in the process was the payment of the Bx. The Trust structure's
primary activity was executing these meaningless monthly transfers, none of which had any economic substance.
The Bx payments under STARS simply represented a rebate to BB & T of one-half of the U.K. taxes to which BB & T
voluntarily subjected itself. The rebates embodied in the Bx payments were directly proportional to the amount of U.K. taxes
paid. The greater the amount of revenue produced by the C Unit distributions of the Trust, the *586 higher the U.K. taxes would
be, and the higher the Bx payments would be to BB & T. STARS thus had the counterintuitive result that the greater the amount
of foreign taxes paid by the taxpayer, the greater the amount of profit realized from the Bx rebate payments.
[20]In evaluating a transaction for pre-tax profit, a court must determine which aspects are real economic effects and thus
non-tax items, and which are tax effects. See In re CM Holdings, Inc., 301 F.3d 96, 103 (3d Cir.2002) ( The main question
these different formulations address is a simple one: absent tax benefits, whether the transaction affected the taxpayer's financial
position in any way.); see also Coltec, 454 F.3d at 1356 n.16; Wells Fargo, 91 Fed.Cl. at 82 (collecting cases). Courts must
isolate tax effects and examine the aspects of the transaction that are economically substantive absent the tax. See Frank Lyon
Co. v. United States, 435 U.S. 561, 573, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) (holding that the objective economic reality
controls rather than the form chosen by the parties); BB & T Corp. v. United States, 523 F.3d 461, 471 (4th Cir.2008) (noting [a]
taxpayer may not ... claim tax benefits ... by affixing labels to its transactions that do not accurately reflect their true nature.);
Wells Fargo, 91 Fed.Cl. at 75-76.
In the Bank of New York case, the Tax Court referred to the Bx payment as the spread, holding:
The spread artificially reduced the loan's cost and lacked economic reality. In substance the spread was contingent on the
parties' anticipated tax treatment and was unrelated to the time value of money or the attendant risks associated with the loan.
We conclude, on the record as a whole, that the spread was in substance not a component of loan interest. The spread rather
was a tax effect. It was embedded in the loan to serve as a device for monetizing and transferring the value of anticipated
foreign tax credits generated from routing income through the STARS structure.
*167 Bank of New York, 140 T.C. at 42-43. By design of the STARS transaction, the value of BB & T's U.K. tax payment
ends up in the hands of Barclays. Barclays then paid BB & T for subjecting itself to a U.K. tax. However, the return to BB &
T of one-half of its U.K. tax did not constitute profit for BB & T. The Bx payment simply reimbursed BB & T for one-half of
its out-of-pocket U.K. tax costs on the transaction. The transaction became immensely profitable to BB & T when it claimed
U.S. foreign tax credits for a U.K. tax cost that it had not in substance paid.
BB & T's artificial pairing of Barclays' Bx payments (representing in substance a rebate of its U.K. tax payments) with BB
& T's interest payments to Barclays, does not reflect economic reality. The economic nature of the Bx payments simply is a
tax effect, and in particular a U.S. tax effect, and not that of a reduction of interest income as BB & T would have the Court
view them.
[21]Income from BB & T's pre-existing assets cycled through the STARS Trust was not profit from STARS. The economic
substance inquiry focuses on whether there was a reasonable possibility of making a profit from the transaction. Stobie
Creek, 608 F.3d at 1376-77. This inquiry focuses on what a reasonably prudent investor would have found from looking at the
transaction prospectively. Id. (citing Gilman v. Comm'r, 933 F.2d 143, 146-47 (2d Cir.1991)); Fidelity Int'l Currency Advisor
A Fund, LLC v. United States, 747 F.Supp.2d 49, 231-32 (D.Mass.2010), aff'd, 661 F.3d 667 (1st Cir.2011). Applying this test,
courts have found that transfers of income-producing assets to controlled entities do not imbue an arrangement with substance
if the transfer has no incremental effect on the taxpayer's activities. Gregory, 293 U.S. at 469, 55 S.Ct. 266 (holding that a
contribution of assets to a special purpose entity did not imbue a transaction with substance); Southgate Master Fund v. United
States, 659 F.3d 466, 491-92 (5th Cir.2011) (disregarding partnership used to acquire loan receivables); Coltec, 454 F.3d at
1354 (disregarding management benefits that were available without undertaking contributions to a special purpose entity);
ACM P'ship v. Comm'r, 157 F.3d 231, 249-52 (3d Cir.1998) (disregarding returns on Citicorp *587 notes where economic
returns on capital were unaffected by the transaction); Zmuda v. Comm'r, 731 F.2d 1417, 1421 (9th Cir.1984) (disregarding
contribution of income-producing assets to foreign trusts); Gerdau Macsteel, Inc. v. Comm'r, 139 T.C. 67, 173-74 (2012) (only
incremental cash flows that the taxpayer would not have obtained in the absence of the transaction should be considered in
testing whether there is a reasonable expectation of non-tax benefits).
[22][23]The Court concludes that the STARS Trust must be disregarded as a sham structure. Under both the economic
substance and substance-over-form doctrines, the creation and use of sham structures to achieve tax benefits are disregarded for
federal tax purposes. Southgate Master Fund, 659 F.3d at 491-92; Schell v. United States, 589 F.3d 1378, 1382 (Fed.Cir.2009);
Fidelity Int'l Currency Advisor, 747 F.Supp.2d at 233 (If a partnership is found to be a sham, the partnership should be
disregarded, and the partnership's activities are deemed to be engaged in by one or more of the partners.). A sham structure
that lacks a non-tax business purpose and is unreal or a bald and mischievous fiction must also be disregarded. Moline
Props., Inc. v. Comm'r, 319 U.S. 436, 439, 63 S.Ct. 1132, 87 L.Ed. 1499 (1943).
The STARS Trust had no non-tax business purpose. Its sole function was to self-inflict U.S.-sourced BB & T income in order
to reap U.S. and U.K. tax benefits. The case law is quite clear that whether the sham be in the entity or the transaction ...
the absence of a nontax business purpose is fatal. ASA Investerings, 201 F.3d at 512; see also Andantech LLC v. Comm'r, 331
F.3d 972, 978 (D.C.Cir.2003).
2. The STARS Loan
[24]The STARS Loan lacked economic substance *168 because it was not structured to make a profit, but instead was
devised to provide BB & T with a pretext for a purported business purpose for engaging in a sham transaction. The Loan simply
was a method by which to camouflage Barclays' rebate of a portion of BB & T's U.K. tax payments, through payment of the
Bx. Absent the tax benefits, the cost of the Loan was considerably higher than BB & T's normal cost of borrowing for similar
loans. The record supports the conclusion that BB & T chose to terminate the transaction when the tax benefits associated with
STARS were threatened. The Loan in reality had no non-tax business purpose and had no possibility of pre-tax profit.
The pre-tax profit test requires an objective analysis from the perspective of a prudent investor of whether there was a
reasonable possibility of making a profit from the transaction apart from tax considerations. Stobie Creek, 608 F.3d at 1376-77.
It is quite true that STARS improved BB & T's bottom line based solely on tax benefits. However, the Bx payment cannot be
considered pre-tax profit on the Loan because it was generated by circular cash flows designed for tax purposes and thus is
purely a tax effect of the transaction.
Excluding the Bx payment, the cost of borrowing on the STARS Loan was LIBOR + 25 basis points. This rate was
significantly higher than rates on comparable sources of funds available to BB & T by a magnitude of 30 basis points or more.
Finard, Tr. 5124-25. BB & T had plenty of less expensive funding resources available during the years in question. Cragg, Tr.
4621-22; USX 1002. Absent strong economic reasons, large commercial banks do not engage in financing transactions at rates
of 25 to 35 basis points higher than their market sources of funding, particularly as to loans over $1 billion. BB & T has not
demonstrated the presence of such economic reasons.
BB & T argues that its interest rate for the STARS Loan should be compared to its interest rates for long-term funding, but
this assertion is incorrect. The term of the funding, like the pricing, must be considered absent the tax benefits. The agreement
with Barclays was that the Loan rate would be based on a 30-day LIBOR rate, and either party had the right to terminate the
transaction within 30 days. The only reason to continue the Loan for the five-year life of STARS was because of the purported
low-cost funding. However, the low-cost funding was entirely the product of the tax benefit, not because of any economic
benefit. Absent *588 the tax benefits, BB & T would have terminated the transaction immediately, which it in fact did in April
2007 when there was concern that the tax benefits would disappear.
In examining the profitability of the STARS transaction, the Court declines to consider the income from BB & T's use of the
Loan proceeds. Although BB & T surely would use the Loan proceeds to generate revenue, this fact is irrelevant for purposes
of the economic substance analysis. See Schering-Plough Corp. v. United States, 651 F.Supp.2d 219, 265-67 (D.N.J.2009)
([T]he use for which a disputed transaction is put is not relevant in determining whether the transaction itself has sufficient
substance.), aff'd sub nom. Merck & Co. v. United States, 652 F.3d 475 (3d Cir.2011); see also In re CM Holdings, Inc., 254
B.R. 578, 638-39 (D.Del.2000) (The Court must focus on the purpose of the underlying transaction at issue here, not what [the
taxpayer] intended to do with the proceeds.... What the cash flows derived from this transaction were to be used for is irrelevant
for ... the economic substance analysis.), aff'd, 301 F.3d 96 (3d Cir.2002); Am. Elec. Power Co., Inc. v. United States, 326 F.3d
737, 744 (6th Cir.2003) (Money generated by means of abusive tax deductions can always be applied to beneficial causes, but
the eventual use of the money thus generated is not part of the economic-sham analysis.); Winn-Dixie Stores, Inc. v. Comm'r,
113 T.C. 254, 287 (1999) (rejecting taxpayer's claim that funding employee benefits with tax savings was legitimate non-tax
business purpose because [i]f this were sufficient to breathe substance *169 into a transaction whose only purpose was to
reduce taxes, every sham tax-shelter device might succeed.), aff'd, 254 F.3d 1313 (11th Cir.2001).
There is no evidence that BB & T took into account the use of the Loan proceeds in deciding whether to enter the STARS
transaction. Under any circumstance, BB & T would have used the Loan proceeds to generate revenue for the bank, regardless
of where it obtained the Loan proceeds. The evidence shows that BB & T viewed the Bx payments as its source of profit on
the STARS transaction. However, a taxpayer must establish with contemporaneous evidence that it objectively anticipated a
profit from the transaction apart from the tax benefits. See Goldstein v. Comm'r, 364 F.2d 734, 739 (2d Cir.1966) (disallowing
deductions where taxpayers' contemporaneous evidence failed to establish any anticipated profit potential apart from tax
consequences of transactions); ACM P'ship, 157 F.3d at 257 (Colgate's failure to conduct a contemporaneous profit analysis
support[s] the Tax Court's conclusion that ACM's transactions were not designed or reasonably anticipated to yield a pre-tax
profit).
Here, the contemporaneous documents show that Barclays, KPMG, and BB & T all considered the profit on STARS to come
solely from Barclays' rebate of the U.K. taxes, with BB & T then claiming foreign tax credits for the amount rebated. The
Loan proceeds should not be taken into account in a profit calculation because such proceeds would have been available in
any alternative funding scenario. Due to the complexity of STARS, BB & T's costs on the STARS Loan are much higher than
they would have been on simpler, alternative funding. STARS did not provide BB & T with any incremental economic benefits
on the Loan.
E. Integrated Transaction Analysis
[25]BB & T contends that the Court should review the STARS transaction as a single integrated agreement, and thereby
evaluate the business purpose of STARS with the Trust and the Loan together. BB & T argues that the existence of the Trust
permits Barclays to offer BB & T a $1.5 billion loan at very favorable interest rates. Viewed in this way, the STARS transaction
simply creates a method in which Barclays and BB & T can use foreign tax credits to provide a sizable loan at 300 basis points
below LIBOR.
[26]Case law instructs the Court to consider the economic realities of a transaction instead of the form of agreement that the
parties employed. In Frank Lyon Co., the Supreme Court ruled:
In applying this doctrine of substance over form, the Court has looked to the objective economic realities of a transaction
rather than to the particular form the parties *589 employed. The Court has never regarded the simple expedient of drawing
up papers as controlling for tax purposes when the objective economic realities are to the contrary. In the field of taxation,
administrators of the law and the courts are concerned with substance and realities, and formal written documents are not
rigidly binding.
435 U.S. at 572-73, 98 S.Ct. 1291 (emphasis added) (citations omitted) (quoting Comm'r v. Tower, 327 U.S. 280, 291, 66
S.Ct. 532, 90 L.Ed. 670 (1946); Helvering v. Lazarus & Co., 308 U.S. 252, 255, 60 S.Ct. 209, 84 L.Ed. 226 (1938)). Similarly,
in Coltec, the Federal Circuit observed:
First, although the taxpayer has an unquestioned right to decrease or avoid his taxes by means which the law permits,
Gregory, 293 U.S. at 469, 55 S.Ct. 266, the law does not permit the taxpayer to reap tax benefits from a transaction that
lacks economic reality.
* * *
Third, the economic substance of a transaction must be viewed objectively rather than subjectively. The Supreme Court
cases and our predecessor court's *170 cases have repeatedly looked to the objective economic reality of the transaction in
applying the economic substance doctrine.
454 F.3d at 1355, 1356 (emphasis added). More recently, in Consolidated Edison, involving a LILO transaction, the Federal
Circuit similarly stated:
As we stated in Coltec, judicial anti-abuse doctrines prevent taxpayers from subverting the legislative purpose of the tax
code. One such doctrine is the substance-over-form doctrine. Under this doctrine, courts determine the tax consequences
of a transaction ... based on the underlying substance of the transaction rather than its legal form. The major purpose of the
substance-over-form doctrine is to recharacterize transactions in accordance with their true nature.
703 F.3d at 1374 (emphasis added) (citations omitted) (quoting Southgate Master Fund, 659 F.3d at 491-92; Wells Fargo,
641 F.3d at 1325; Coltec, 454 F.3d at 1354).
Applying these principles here, the STARS transaction must be seen for what it really is. By creating a trust arrangement with
nothing but circular cash flows, and momentarily placing funds in the hands of a U.K. trustee before it is returned, Barclays
and BB & T artificially caused a U.K. tax on U.S.-sourced revenue. There was no substantive economic activity occurring in
the U.K. to warrant a U.K. tax. Yet, by subjecting the Trust funds to a U.K. tax, Barclays and BB & T were able to share the
benefits of foreign tax credits, which resulted in a 51 percent rebate of a Bx payment to BB & T. The surprisingly low interest
rate to BB & T on the $1.5 billion Loan, 300 basis points below LIBOR, was made possible solely because of the fruits of the
Trust arrangement. In reality, the U.S. Treasury is funding the monetary benefits realized by BB & T, Barclays, and the U.K.
Treasury. No aspect of the STARS transaction has any economic reality.
F. Penalties
[27][28]The Federal tax system is primarily one of self-assessment, whereby each taxpayer computes the tax due and then
files the appropriate form of return along with the requisite payment. United States v. Galletti, 541 U.S. 114, 122, 124 S.Ct.
1548, 158 L.Ed.2d 279 (2004) (internal quotation marks omitted). When a taxpayer underpays his taxes due to, inter alia,
negligence or a substantial understatement of tax, the Internal Revenue Code assesses penalties. 26 U.S.C. 6662. Section
6662 imposes a 20 percent penalty on any portion of an underpayment that is attributable to [n]egligence or disregard of rules
or regulations or [a]ny substantial understatement of income tax. 6662(b)(1-2). These accuracy-related penalties are not
cumulative; therefore, the maximum accuracy-related penalty imposed on any portion of an understatement is 20 percent. Treas.
Reg. 1.662-2(c); Alpha I, L.P. v. United States, 93 Fed.Cl. 280, 301 (2010). As will be discussed below, 6664(c)(1) provides
an absolute defense to accuracy-related penalties assessed for an underpayment if it is shown that there was reasonable cause
for such portion and that the taxpayer acted in good faith with respect to such portion.
*590 The Government asserts that BB & T is subject to penalties for negligence and substantial understatement of income
tax. Plaintiff asserts the defenses of substantial authority, reasonable reliance on tax professionals, adequate disclosure, and
reasonable cause and good faith.
1. Negligence
[29]Section 6662 imposes an accuracy-related penalty of 20 percent for any portion of the underpayment which is attributable
to [n]egligence or disregard of rules or regulations. 6662(b). For purposes of this penalty, the term negligence includes
any failure to make a reasonable attempt to comply with the provisions of this title, and the term disregard includes any
careless, reckless, or intentional *171 disregard of tax rules and regulations. 6662(c). Negligence is strongly indicated
where ... [a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on
a return which would seem to a reasonable and prudent person to be too good to be true under the circumstances. Treas.
Reg. 1.6662-3(b)(1)(ii). [W]hen a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax
obligations, he should recognize that he proceeds at his own peril. Alpha I, 93 Fed.Cl. at 302 (quoting Neonatology Assocs.,
P.A. v. Comm'r, 299 F.3d 221, 234 (3d Cir.2002)) (internal quotation marks omitted).
[30][31][32]A taxpayer is not negligent when there is a reasonable basis for the position taken. Treas. Reg. 1.6662-3(b)(1).
The reasonable basis standard is relatively high, and is not satisfied by a return position that is merely arguable or that is merely
a colorable claim. Id. at 1.6662-3(b)(3). Good faith reliance on professional advice may provide a reasonable basis, but such
reliance must be objectively reasonable; taxpayers may not rely on someone with an inherent conflict of interest.... Stobie
Creek, 82 Fed.Cl. 636, 709 (2008) (quoting Chamberlain v. Comm'r, 66 F.3d 729, 732 (5th Cir.1995)). Thus, the defense of
reliance on professional advice prevails only if, under all the circumstances, (1) the advice itself is reasonable ... and (2) the
taxpayer's reliance thereon is reasonable. Stobie Creek, 82 Fed.Cl. at 712.
a. Reasonableness of the advice
[33][34]In determining whether the professional advice itself was reasonable, courts look to whether the advice is based
on accurate information and representations supplied by the taxpayer, whether there was a reasonable investigation into the
transaction, and whether it contains any unreasonable or unsupported assumptions. Id. Here, KPMG was the principal marketer
of STARS, and provided BB & T with advice as to the viability and profitability of the transaction. As discussions between
KPMG and BB & T progressed, BB & T became concerned that if challenged, the IRS may determine that STARS lacked
economic substance. KPMG advised BB & T that the possibility of a court finding BB & T to have engaged in a sham transaction
was so remote as to not need to be considered. USX 564. KPMG further advised that even if STARS was found to lack
economic substance, BB & T would nevertheless be allowed a deduction for the U.K. taxes. Monger, Tr. 1253-55. The Court
finds this assertion (and BB & T's reliance thereon) to be unreasonable and unsupported. KPMG's assumption that BB & T
could claim a deduction for U.K. taxes even if STARS was found to lack economic substance flies in the face of the accepted
principle that a transaction lacking in economic substance is disregarded for tax purposes. See, e.g., Coltec, 454 F.3d at 1355.
KPMG's overarching advice was that BB & T should engage in an economically meaningless transaction to achieve foreign tax
credits for taxes BB & T had not in substance paid. Thus, because KPMG's advice was based on unreasonable and unsupported
assumptions, the Court finds KPMG's advice unreasonable.
[35]Based on KPMG's recommendation, BB & T also selected the law firm of Sidley Austin, and in particular, Raymond J.
Ruble, to provide tax advice and a formal opinion on STARS. BB & T did not formerly engage Sidley Austin until May 7, 2002.
JX 264. However, on April 30, 2002, Mr. Ruble forwarded to BB & T a redacted tax opinion endorsing the STARS transaction,
which had *591 been prepared for another client. USX 599; Monger, Tr. 927. This tax opinion detailed a very similar STARS
transaction, with the exact same entity names, such as InvestCo, Manager, NewCo, and DelCo. USX 599; Monger, Tr. 927-28.
Although the final BB & T STARS tax opinion was tailored in part to BB & T specifically, a review of Mr. Ruble's other
legal tax opinions on the STARS transaction reveals that his favorable opinions were largely pre-fabricated and predetermined.
Compare PX 174 with USX 1502 and USX 464. Similar to the advice of KPMG, Sidley *172 Austin's advice and opinion
letters endorsed and advocated the promulgation of economically meaningless transactions. Because Sidley Austin's tax opinion
was premised on the unreasonable and unsupported assumption that technical compliance with U.S. tax law would allow the
IRS to give its imprimatur to an economically meaningless transaction, the Court finds Sidley Austin's advice unreasonable.
b. Reasonableness of the reliance
[36][37]In determining whether a taxpayer's reliance on professional advice was reasonable, courts evaluate any potential
conflict of interest, the taxpayer's knowledge and expertise, and whether the transaction seems too good to be true. See, e.g.,
Stobie Creek, 82 Fed.Cl. at 712; Neonatology, 299 F.3d at 233-34. As mentioned above, KPMG was the principal promoter
of STARS to BB & T. KPMG marketed the STARS transaction to BB & T, and would not receive any of its $6.5 million fee
unless and until BB & T closed on the STARS transaction. Prior to the closing date of STARS, BB & T knew that KPMG was
involved in the design of the STARS structure and that KPMG reviewed Barclays' design of the STARS transaction. Monger,
Tr. 614-19. BB & T also was aware that KPMG was on both sides of the transaction between Barclays and BB & T, and that
KPMG thus had a blatant conflict of interest. PX 67. Indeed, the head of KPMG's Department of Professional Practice for tax
matters expressed concern about KPMG's ability to issue a should-level opinion. DeLap Dep., 62-67, 75-76; USX 241; USX
243. Despite knowing that KPMG had prior involvement with the STARS transaction, BB & T did not seek an independent
tax opinion. Watson, Tr. 2845. [FN12]
Similarly, at the time BB & T received Sidley Austin's tax opinion and subsequently retained the law firm (on KPMG's
recommendation), BB & T was aware that Sidley Austin was a co-developer of STARS and that it had previously provided a
favorable tax opinion of STARS to another bank. Monger, Tr. 615-16; JX 255. Thus, both KPMG and Sidley Austin stood to
profit considerably from BB & T's adoption of the transaction, and BB & T knew or should have known that their advice would
not be impartial and independent. In agreeing to Sidley Austin's engagement letter, BB & T was asked to waive any conflicts
that Sidley Austin had with Barclays, but BB & T did not even inquire about the services that Sidley Austin was or had been
performing for Barclays. Monger, Tr. 1297-99. As the Third Circuit stated in Neonatology:
It may well be that reliance on the advice of a professional should only be a defense when the professional's fees are not
dependent on his opinion. For example, it is not immediately evident why a taxpayer should be able to take comfort in the
advice of a professional promoting a tax shelter for a fee. After all, that professional would have an interest in his opinion.
299 F.3d at 234 n.22. Because both KPMG and Sidley Austin [FN13] had a significant interest *592 in convincing BB & T
to engage in the STARS transaction, the Court cannot say that BB & T acted reasonably in relying on their advice. See Alpha
I, 93 Fed.Cl. at 316 (It is well established that taxpayers generally cannot reasonably rely on the professional advice of a tax
shelter promoter.) (quoting Edwards v. Comm'r, 84 T.C.M. (CCH) 24 (2002)); Pasternak v. Comm'r, 990 F.2d 893, 903 (6th
Cir.1993) (upholding negligence penalty where the purported experts were either the promoters themselves or agents of the
promoters. Advice of such persons can hardly be described as that of independent professionals.). Here, Sidley Austin sent
BB & T a favorable draft opinion letter about STARS before BB & T had even engaged this law firm. Monger, Tr. 1265-67.
*173 BB & T's engagement with PwC is insufficient to remove the taint of unreasonableness from the professional tax
advice relied upon. PwC's involvement in the STARS transaction does not create a reasonable basis for BB & T's tax position
because: (1) BB & T reported only Barclays, KPMG, and Sidley Austin as its tax advisors to the STARS transaction, JX 234;
(2) PwC explicitly informed BB & T that it in no way [was] providing an Opinion regarding STARS, JX 259; and (3) PwC's
audit advice was informed by the unreasonable and unsupported representations made by KPMG and Sidley Austin, Boss, Tr.
2042-46; USX 568; JX 859. Moreover, PwC ultimately arrived at a less than should level of comfort that the IRS would
accept the STARS transaction. Boss, Tr. 2098, 2117-18; USX 951A at 7183-84; USX 553, 601, 611. During exceptional cross-
examination by Defendant's counsel, PwC's Mr. Boss was evasive and had few answers for the glaring weaknesses that PwC
should have seen in the STARS transaction. Boss, Tr. 2131-41.
Additionally, the BB & T executives that reviewed the economic and tax effects of the STARS transaction are highly educated
and well-versed in banking transactions and financing deals. These individuals knew or should have known that claiming nearly
$500 million in foreign tax credits by subjecting income to economically meaningless activities was too good to be true.
Indeed, the evidence shows that BB & T executives were extremely skeptical of the tax benefits of STARS, as the potential
downside tax risks were the subject of much correspondence and presentation. Monger, Tr. 1102-04, 1126-37; Watson, Tr.
3466-69. Moreover, Mr. Monger generated many spreadsheet analyses calculating BB & T's potential economic return on
STARS in the event that the IRS disallowed the foreign tax credits. USX 437.
BB & T's concern over the tax risk was significantly reflected in the negotiations and eventual fee arrangement with KPMG. In
a meeting with KPMG, BB & T representatives expressed a concern[ ] that KPMG needs to have some of the fee at risk[ ] and
a desire to reduce [BB & T's] exposure in the event of an early termination of the transaction. Monger, Tr. 1156-57; USX 470.
BB & T negotiated that KPMG would provide audit assistance if the IRS challenged the transaction. JX 254. This skepticism
on the part of BB & T was well-founded, because as a successful financial holding company with banking subsidiaries in over
twelve states, JX 209, it surely would have recognized that the ability to claim nearly $500 million in foreign tax credits merely
by subjecting its assets to U.K. taxation was too good to be true. See Neonatology, 299 F.3d at 234 (When, as here, a taxpayer
is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds
at his own peril.).
Thus, the fact that BB & T relied on the advice of promoters of the STARS tax shelter despite having ample capacity to
recognize that the transaction was too good to be true, thoroughly vitiates any reasonable basis for BB & T's tax position.
Accordingly, Plaintiff is liable for the 20 percent negligence penalty, unless it can establish reasonable cause and good faith,
a defense addressed below.
*174 2. Substantial Understatement
Under 6662, an understatement is substantial if it exceeds the lesser of 10 percent of the tax required to be shown on the
return *593 for the taxable year or $10,000,000. [FN14] 6662(d)(1)(B). The amount of any understatement can be reduced for
any portion as to which the taxpayer can either establish substantial authority for the position the taxpayer took or demonstrate
a reasonable basis for the claimed tax treatment, coupled with adequate disclosure. 6662(d)(2)(B). For the tax years at issue,
these defenses are modified when a tax shelter is involved. See, e.g., 6662(d)(2)(C); Stobie Creek, 82 Fed.Cl. at 705.1 [FN15]
[38]To avoid the penalty in the case of a corporate tax shelter, the taxpayer must establish (1) that there was substantial
authority for the tax treatment and (2) that the taxpayer reasonably believed that the reported treatment of an item was more likely
than not the proper treatment. Treas. Reg. 1.6662-4(g)(1); see also 6662(d)(2)(C)(i); Alpha I, 93 Fed.Cl. at 321. [FN16] The
substantial authority standard is an objective standard, which is met only if the weight of the authorities supporting the treatment
is substantial in relation to the weight of the authorities supporting contrary treatment. Treas. Reg. 1.6662-4(d)(3)(i). The
weight given to each authority depends on its relevance, persuasiveness, and source. Id. 1.6662-4(d)(3)(ii). Conclusions
reached in treaties, legal periodicals, legal opinions, or opinions rendered by tax professionals are not authority. Id. at
1.6662-4(d)(3)(iii); Alpha I, 93 Fed.Cl. at 322 (Reliance on advice by tax professionals is specifically excluded in deciding
whether substantial authority exists for a particular tax treatment.). When a transaction is found to lack economic substance,
no authority, much less substantial authority, supports the claimed tax treatment. Stobie Creek, 82 Fed.Cl. at 706, 706 n.64,
(finding that transactions lacked economic substance precluded plaintiffs from establishing existence of substantial authority
to support tax treatment).
[39]As discussed in detail above, the STARS transaction lacked economic reality because it was unsupported by a tax-
independent business purpose. Thus, because the transaction's significant purpose was the avoidance or evasion or Federal
income tax, STARS falls within the statutory definition of a tax shelter. 6662(d)(2)(C)(iii). Not only was the STARS
transaction a tax shelter, but it was also an economically meaningless transaction. The STARS transaction was no more than a
circular redirection of cash flows from the U.S. Treasury to BB & T, Barclays, and the U.K. Treasury. The Court's determination
that STARS lacked economic substance precludes Plaintiff from establishing the first prong of its defense, as there is no
authority, much less substantial, that supports a subterfuge for generating, monetizing and transferring the value of foreign tax
credits.... Bank of New York, 140 T.C. at 31; see Stobie Creek, 82 Fed.Cl. at 706 n.64 ([N]o substantial authority exists to
support recognition of tax results that are premised on transactions with no appreciable business purpose beyond conferring tax
benefits.); Long Term Capital Holdings v. United States, 330 F.Supp.2d 122, 204-05 (D.Conn.2004) (holding that taxpayer
cannot cite *175 authority to support tax treatment once transaction is deemed to lack economic substance). Because the Court
finds that substantial authority does not support the tax treatment claimed by BB & T, the Court need not address whether BB
& T reasonably believed that the tax treatment claimed was more likely than not the proper treatment. Plaintiff is liable for the
20 percent substantial understatement penalty. Whether the reasonable cause and good faith exception provides BB & T with
a valid defense to the substantial understatement penalty is addressed below.
*594 3. Reasonable Cause and Good Faith
[40]Section 6664(c)(1) provides an absolute defense to the imposition of any accuracy-related penalty:
No penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that
there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.
The taxpayer bears the burden of showing that this exception applies. Stobie Creek Invs. LLC v. United States, 608 F.3d
1366, 1381 (Fed. Cir.2010) (citing Conway v. United States, 326 F.3d 1268, 1278 (Fed. Cir.2003)). Reliance on professional
advice may constitute reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the
taxpayer acted in good faith. Treas. Reg. 1.6664-4(b)(1). In determining whether a taxpayer has reasonably relied in good
faith on advice as to the tax treatment, all facts and circumstances must be taken into account, including but not limited to
the taxpayer's education, sophistication, and business experience[.] Id. at 1.6664-4(c)(1). Additionally, the advice must
be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances[,] must not be
based on unreasonable factual or legal assumptions (including assumptions as to future events) [,] and must not unreasonably
rely on the representations, statements, findings, or agreements of the taxpayer or any other person. Id. The satisfaction of
these requirements will not necessarily establish that the taxpayer reasonably relied on the advice in good faith. Id. Reliance is
not reasonable, for example, if the adviser has an inherent conflict of interest about which the taxpayer knew or should have
known, or if the taxpayer knew or should have known that the transaction was too good to be true. Stobie Creek, 608 F.3d
at 1382-83 (citing, inter alia, Treas. Reg. 1.6664-4(c)).
[41]As discussed above, the unsupportable assumptions upon which the promoters' advice was based, the conflicts of interest
of the STARS promoters, and the BB & T's executives' high level of knowledge and expertise preclude a finding of reasonable
reliance on professional advice. Similarly, the weight of the evidence shows that tax avoidance was singularly and precisely
the goal pursued in execution of the STARS transaction. Consequently, the Court finds that BB & T did not act with reasonable
cause and good faith with regard to any portion of the underpayment determined.
For the foregoing reasons, the Court finds that Plaintiff was engaged in an economically meaningless tax shelter, that the
negligence accuracy-related penalty of 6662(b)(1) and the substantial understatement accuracy-related penalty of 6662(b)
(2) apply, and that the defenses of reasonable basis, substantial authority, and reasonable cause and good faith are not available
to Plaintiff.
III. Conclusion
The Court finds in favor of Defendant on all grounds. Plaintiff's claims for tax refund are DENIED in their entirety. Before
entering final judgment, the Court will conduct a conference with counsel of record on a mutually agreeable date to confirm the
proper amount and terms of the judgment. Pursuant to Rule 54(d), the Court awards costs to Defendant as the prevailing party.
*176 IT IS SO ORDERED.
Fed.Cl., 2013
Salem Financial, Inc. v. United States
112 Fed.Cl. 543, 112 A.F.T.R.2d 2013-6168, 2013-2
USTC P 50,517
*177 F.Supp.2d , 2013 WL 5651414 (D.Mass.), 112 A.F.T.R.2d 2013-6530, 2013-2 USTC P 50,564
(Cite as: 2013 WL 5651414 (D.Mass.))
United States District Court, D. Massachusetts. SANTANDER HOLDINGS USA,
INC. & SUBSIDIARIES, Plaintiff, v. UNITED STATES of America, Defendant.
Civil Action No. 09-11043-GAO.
Oct. 17, 2013.
Background: Taxpayer sued United States, seeking to recover $234 million in federal income taxes, penalties, and interest
that were allegedly improperly assessed and collected by Internal Revenue Service (IRS) for three tax years due to IRS's
disallowance of foreign tax credits claimed by taxpayer for allegedly sham transaction that IRS alleged was mere tax-avoiding
contrivance. Taxpayer moved for partial summary judgment.
Holding: The District Court, O'Toole, J. held that payment received by taxpayer for transaction was pre-tax income rather
than effective tax rebate.
Motion granted.
West Headnotes
220V Income Taxes
220V(A) In General
220k3071 k. Substance or Form of Transaction. Most Cited Cases
Under the economic substance doctrine, otherwise known as substance over form doctrine, sham transaction doctrine,
and even the sham in substance doctrine, if a transaction has no legitimate, non-tax business purpose and thus, apart from
expected tax benefits, has no genuine economic substance, it may be disregarded for purposes of assessing taxes.
220V Income Taxes
220V(A) In General
Under the economic substance doctrine, a transaction will be found to have economic substance if it had a reasonable
possibility of a profit.
220V Income Taxes
220k4099 k. In General. Most Cited Cases
British bank's payment to United States bank in structured trust advantaged repackaged securities (STARS) transaction, for
which United States bank incurred and paid foreign taxes and then claimed foreign tax credits on its federal income taxes,
was not sham tax-avoiding contrivance without economic *178 substance, but rather was appropriately regarded as income
to United States bank, fully consistent with letter and substance of Internal Revenue Service (IRS) regulations and case law,
despite IRS's allegation that payment was effectively rebate of United Kingdom taxes, since payment was private and thus not
tax item. 26 U.S.C.A. 61(a)(12); 26 C.F.R. 1.901-2(f)(1), (f)(2)(i).
220V Income Taxes
220V(D) Incomes Taxable in General
220k3141 k. Taxes Paid by Another. Most Cited Cases
The terms taxes and tax credits are properly understood to refer to transactions between a taxpayer and a taxing authority,
not transactions between private parties, even if the effect is to lessen for a taxpayer the economic burden of having paid the tax.
220V Income Taxes
220V(A) In General
The economic substance doctrine allows the Internal Revenue Service (IRS) to look beyond technical compliance with the
Internal Revenue Code to ascertain the real nature of the transaction at issue; however, economic substance still must be assessed
in adherence to accepted and usual legal and accounting principles.
220V Income Taxes
Taxes paid on behalf of a taxpayer are counted as income to the taxpayer. 26 C.F.R. 1.901-2(f)(1, 2).
220V Income Taxes
Payments between private parties, even if they are buying and selling tax credits, are income to be accounted for on a pre-
tax basis. 26 C.F.R. 1.901-2(f)(1, 2).
Christopher Bowers, Rajiv Madan, John Magee, Christopher P. Murphy, Royce Tidwell, Nathan P. Wacker, Nicholas L.
Wilkins, Bingham McCutchen LLP, Washington, DC, Deana K. El-Mallawany, James C. McGrath, Bingham McCutchen LLP-
MA, Boston, MA, for Plaintiff.
Raagnee Beri, William E. Farrior, Alan S. Kline, Kari M. Larson, John L. Schoenecker, U.S. Department of Justice, Dennis
M. Donohue Washington, DC, for Defendant.
OPINION
O'TOOLE, District Judge.
*1 Santander Holdings USA, Inc., formerly known as Sovereign Bancorp, Inc., and referred to in this opinion as Sovereign,
has sued to recover approximately $234 million in federal income taxes, penalties, and interest that it claims were improperly
*179 assessed and collected by the Internal Revenue Service for tax years 2003, 2004, and 2005 as a consequence of the IRS's
disallowance of foreign tax credits claimed by Sovereign for those years. The United States defends the disallowance on the
ground that the transaction in which Sovereign incurred and paid the foreign taxes against which the credit was taken was a
sham conducted not for its real economic value but rather as a contrived means of generating the tax benefit provided by
the foreign tax credit.
Sovereign recently moved for partial summary judgment on a linchpin issue: whether a payment Sovereign received in the
transaction from its counterparty, Barclays Bank PLC (Barclays), should be accounted for as revenue to Sovereign in assessing
whether Sovereign had a reasonable prospect of profit in the transaction. It is the government's position that the payment should
be excluded from a calculation of Sovereign's pre-tax profit as a tax effect because the payment is an effective rebate of
U.K. taxes paid by Sovereign. If the payment is excluded, as the government contends it should be, then the transaction at
issue does not show a reasonable prospect of profit, but if it is included, as Sovereign contends, it shows a substantial profit to
Sovereign from the transaction. This basic binary fact is not genuinely disputed. The existence or not of a reasonable prospect
of profit is critical in determining whether the transaction had objective economic substance for purposes of assessing whether
it was a sham or not. If the payment is counted as pre-tax revenue, it is objectively clear that the transaction has economic
substance for Sovereign.
The parties submitted voluminous briefing on the matter and were heard in extended oral argument. At a pretrial conference
on September 25, 2013, I announced from the bench that Sovereign's motion for partial summary was being granted. I gave a
brief oral statement of my reasoning, promising a more detailed written opinion to come. This is that opinion, and it supersedes
the brief oral statement of reasons.
I. The STARS Transaction
Barclays is chartered by the United Kingdom. Together with its adviser, KPMG, Barclays developed and proposed to several
U.S. banks, including Sovereign, a Structured Trust Advantaged Repackaged Securities (STARS) transaction. Viewed from
30,000 feet, the STARS transaction was designed to give Barclays substantial benefits under U.K. tax laws, in light of which
Barclays could and would offer to lend funds to U.S. banks at a lower cost than otherwise might be available to them. The banks
could relend the money in their normal banking operations, using the lower cost either to obtain a competitive advantage or to
increase their marginal return on lending or both. Up close, however, the transaction was surpassingly complex and unintuitive;
the sort of thing that would have emerged if Rube Goldberg had been a tax accountant. The government might be forgiven for
suspecting that the designers of anything this complex must be up to no good, but that understandable instinctive reaction is not
a substitute for careful analysis, and on careful analysis, the government's position does not hold up.
*2 A very brief overview of the transaction is sufficient for present purposes. Sovereign created a trust to which it contributed
$6.7 billion of income generating assets. The trustee of the trust was purposely made a U.K. resident, causing the trust's income
to be subject to U.K. income taxation at a rate of 22 percent. The trust income was also subject to U.S. income taxation and was
attributed to Sovereign, but with a credit available for the amount paid in U.K. income taxes under section 901 of the Internal
Revenue Code (the Code). 26 U.S.C. 901. Sovereign paid U.K. taxes and then claimed credits for the amounts paid in
calculating its U.S. income tax liability for the tax years in question.
The transaction included a number of contrived structures and steps that, each viewed in isolation, would make little or no
sense. For example, Barclays *180 had an ownership interest in the trust and as a result received monthly distributions from the
trust, which, under the terms of the transaction, it was required immediately to re-contribute to the trust. Standing in isolation,
this circular movement of distributions would make no sense. In the context of the entire transaction, however, it was crucial
to Barclays' obtaining favorable tax treatment under U.K. law, which gave it the ability to lower its effective lending rate to
a U.S. bank. The result of the STARS transaction for Barclays was a net tax gain, which it was able to use to reduce other
U.K. tax liabilities that it owed. [FN1]
The loan aspect of the transaction was also highly structured in an idiosyncratic way, although it was consistently treated
by Sovereign for accounting and regulatory purposes as a secured loan, acceptably to regulating agencies, including the
Securities and Exchange Commission and the Office of Thrift Supervision. One feature of the loan arrangements was what was
denominated the bx payment, or the Barclays payment. [FN2] It was calculated as approximately one-half of the amount
Sovereign paid in taxes to the U.K. on the income earned by the trust. While in the intricacies of the transaction it was actually
a monthly credit to Sovereign figured into its interest costs, the government refers to it as an affirmative payment in support of
its effective rebate argument, and Sovereign accepts that characterization for purposes of this motion. [FN3]
II. Discussion
There is no dispute that for the years in question Sovereign incurred and paid U.K. taxes on the trust income, also reported
the income on its U.S. tax returns, but claimed a foreign tax credit for the amount it paid to the U.K. There is no claim by
the government that the foreign tax credit was improperly calculated or that Sovereign failed to comply with any applicable
provision of statute or regulation relative to it. Rather, the government's position is that Sovereign did not in substance pay
the U.K. taxes claimed because the Barclays payment was an effective rebate of one-half of Sovereign's U.K. taxes. In other
words, the Barclays payment effectively relieved Sovereign of half the burden of its U.K. taxes.
*3 [1][2] In order to challenge what would otherwise be a valid claim of a foreign tax credit, the government reaches for
its trump card--the economic substance doctrine. Cf. In re CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir.2002) (referring
to the economic substance doctrine as the government's trump card). Literal compliance with the letter of the Code and
regulations may be disregarded if it appears that the transaction in question had no economic substance but was simply a tax-
avoiding contrivance. Gregory v. Helvering, 293 U.S. 465, 470, 55 S.Ct. 266, 79 L.Ed. 596 (1935). The same principle has
been articulated variantly as the substance over form doctrine, see Frank Lyon Co. v. United States, 435 U.S. 561, 573, 98
S.Ct. 1291, 55 L.Ed.2d 550 (1978), the sham transaction doctrine, see IES Indus., Inc. v. United States, 253 F.3d 350, 353
(8th Cir.2001), and even the sham in substance doctrine, see Dewees v. C.I.R., 870 F.2d 21, 29 (1st Cir.1989). The principle
is the same regardless of the label: if a transaction has no legitimate, non-tax business purpose and thus, apart from expected
tax benefits, has no genuine economic substance, it may be disregarded for purposes of assessing taxes. See CM Holdings,
301 F.3d at 103 (The main question these different formulations address is a simple one: absent the tax benefits, whether the
transaction affected the taxpayer's financial position in any way.). A transaction will be found to have economic substance if
it had a reasonable possibility of a profit. Fid. Int'l Currency Advisor A Fund, LLC, by Tax Matters Partner v. United States,
747 F.Supp.2d 49, 231 (D.Mass.2010), aff'd sub nom. Fid. Int'l Currency Advisor A Fund, LLC ex rel. Tax Matters Partner
v. United States, 661 F.3d 667 (1st Cir.2011).
[3] The government says the Barclays payment was not in substance a payment by Barclays at all, but rather it was
effectively a rebate of taxes originating *181 from the U.K. tax authorities. The theory is that Barclays was only able to
make the payment because of the tax credits it had received from the U.K.
The argument is wholly unconvincing. In the first place, the Code and regulations contain explicit provisions addressing
when a foreign tax may be considered rebated by the taxing authority and when a taxpayer may be considered to have received
a subsidy (a rebate is a type of subsidy) from a foreign source to pay its foreign taxes. Under the Code,
Any income, war profits, or excess profits tax shall not be treated as a tax for purposes of this title 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, a related person (within the meaning of section 482), 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.
26 U.S.C. 901(i)(1)-(2). Treasury Regulations provide:
*4 An amount is not tax paid to a foreign country to the extent that it is reasonably certain that the amount will be refunded,
credited, rebated, abated, or forgiven. It is not reasonably certain that an amount will be refunded, credited, rebated, abated,
or forgiven if the amount is not greater than a reasonable approximation of final tax liability to the foreign country.
26 C.F.R. 1.901-2(e)(2). Further,
(i) General rule. An amount of foreign income tax is not an amount of income tax paid or accrued by a taxpayer to a
foreign country to the extent that--(A) The amount is used, directly or indirectly, by the foreign country imposing the tax to
provide a subsidy by any means (including, but not limited to, a rebate, a refund, a credit, a deduction, a payment, a discharge
of an obligation, or any other method) to the taxpayer, to a related person ..., to any party to the transaction, or to any party
to a related transaction; and
(B) The subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used
to compute the amount of the tax.
(ii) Subsidy. The term subsidy includes any benefit conferred, directly or indirectly, by a foreign country to one of the
parties enumerated in paragraph (e)(3)(i)(A) of this section. Substance and not form shall govern in determining whether a
subsidy exists. The fact that the U.S. taxpayer may derive no demonstrable benefit from the subsidy is irrelevant in determining
whether a subsidy exists.
26 C.F.R. 1.901-2(e)(3) (emphasis added). In pretrial discovery, the government abjured any claim that the Barclays
payment was a subsidy under these provisions. (See Pl.'s Mem. in Supp. of Mot. for Partial Summ. J., Ex. 4 at 16 (dkt. no.
125-4) (Response to Interrogatory No. 41).) As the emphasized sentence indicates, that concession must be understood to
mean that the Barclays payment was not in substance a subsidy.
Nevertheless, the government presses its argument that the Barclays payment was in substance a rebate from the U.K. But
the government can point to no governing or precedential legal authority that supports treating the private payment between
Barclays and Sovereign as a payment from the U.K. treasury, because there is none. It has some decisions at the first-instance
level that have generally accepted its theory about the STARS transaction, but as this opinion explains, I find those decisions
unpersuasive.
Lacking compelling legal authority, the government proffers the learned opinions of its putative expert witnesses. The problem
is that their opinions do *182 not matter, because the necessary question is not a question of fact--What happened?--but rather
a question of law--How should what happened be classified for purposes of applying the law? That is why this issue is amenable
to resolution on a motion for summary judgment. The facts of the transaction are not in dispute. There is no material factual issue
about how the credits and debits worked their labyrinthine way through the Goldbergian apparatus. The question is, Should the
Barclays payment be treated, as a matter of law, as if it were a rebate from the U.K. to Sovereign? That is a legal question, to be
answered by judges, not economists. See IES, 253 F.3d at 351 (The material facts are undisputed; the question of law before
us is the general characterization of a transaction for tax purposes.).
*5 [4] The Barclays payment was certainly not an actual rebate by the U.K. [FN4] Nor is there any reason to treat it as an
effective or constructive rebate. There is no authority to do so. On the contrary, the terms taxes and tax credits are
properly understood to refer to transactions between a taxpayer and a taxing authority, not transactions between private parties,
even if the effect is to lessen for a taxpayer the economic burden of having paid the tax. See Doyon, Ltd. v. United States,
37 Fed.Cl. 10, 22-24 (1996), rev'd on other grounds, 214 F.3d 1309 (Fed.Cir.2000). In Doyon, the Court of Federal Claims
rejected a taxpayer's argument that certain payments to it from other private parties should have been allowed as an adjustment
to its net book income for tax purposes because the payments were effectively the same as a tax item in substance. Contrary to
its argument in this case, the government contended in Doyon that amounts paid between private parties pursuant to private
contracts are not and cannot be federal income taxesDDD within the meaning of the applicable Code provision and related
regulations. Id. at 17 (summarizing the government's contention). The court there agreed with the government that private
payments were not tax items, concluding that an item of federal tax benefit is an abatement of liability under the revenue laws,
and further that even if the federal Treasury could be regarded as the ultimate source of the private party payment, the
payment was still private and therefore not a tax item. Id. at 22-23. Sovereign also cites some private letter rulings that similarly
look to whether the taxing authority was actually a party to a transfer of a payment or credit, and not to the economic substance
of the event, to determine whether the matter was a tax item or a private transaction. See I.R.S. Priv. Ltr. Rul. 2009-51-024
(Dec. 18, 2009); I.R.S. Priv. Ltr. Rul. 2003-48-002 (Nov. 28, 2003); I.R.S. Priv. Ltr. Rul. 87-42-010 (July 10, 1987).
Slight as this authority may be, it is enough to outweigh the government's authority for its proposition that a private payment
may be recharacterized into a tax item, which is nil. The recent decisions in similar STARS cases do not discuss the issue. See
Salem Fin., Inc. v. United States, 112 Fed.Cl. 543, 585- 87 ( 2013); Bank of N.Y. Mellon Corp. v. C.I.R., 140 T.C. 15, 40-43
(Feb. 11, 2013). Those cases appear to deal with the question whether the Barclays payment was in substance a tax effect
as a matter of fact, rather than as a matter of law, as I conclude is proper. In other words, they accept the testimony of the
government's experts and make a factual finding that the Barclays payment was an effective U.K. tax rebate and consequently
a U.S. tax effect. Salem Fin., 112 Fed.Cl. at 586- 87; Bank of N.Y., 140 T.C. at 43. Notably, they do not address the legal
question whether a private party payment between Barclays and the relevant bank can properly be classified as a tax effect
because it is so much like one in substance, a question that Doyon and the private letter rulings answer in the negative.
*6 Moreover, the Code and regulations have addressed the issues of rebates and subsidies and stopped short of any concept
of constructive or effective rebate. If there were to be such a new principle adopted, and it would be a new principle, it
would be *183 better done through the legislative and rulemaking processes where the focus is broad, rather than through
adjudication where the focus is particular and possibly outcome-driven.
[5] The economic substance doctrine allows the government to look beyond technical compliance with the Code to ascertain
the real nature of the transaction at issue. However, economic substance still must be assessed in adherence to accepted and usual
legal and accounting principles. See Compaq Computer Corp. & Subsidiaries v. C.I.R., 277 F.3d 778, 784-86 (5th Cir.2001).
Otherwise, the government's trump card would acquire too much potency. Here, treating the Barclays payment as revenue to
the taxpayer is not a manipulative distortion of the tax rules to achieve merely technical compliance, but rather is fully consistent
with not only the letter but the substance of the IRS's own regulations and existing case law. See Compaq Computer Corp.
& Subsidiaries, 277 F.3d at 784-85 (collecting cases); IES Indus., Inc., 253 F.3d at 354; 26 U.S.C. 61(a)(12); 26 C.F.R.
1.901-2(f)(1)-(2)(i).
[6] Barclays' assumption of part of Sovereign's tax liability is properly regarded as income to Sovereign. It is a hoary principle
dating to the earliest days of the income tax that taxes paid on behalf of a taxpayer are counted as income to the taxpayer. Old
Colony Trust Co. v. C.I.R., 279 U.S. 716, 729, 49 S.Ct. 499, 73 L.Ed. 918 (1929). It is still vital. See IES Indus., Inc. v. United
States, 253 F.3d 350, 354 (8th Cir.2001); accord Compaq Computer Corp. & Subsidiaries, 277 F.3d at 784.
This principle is also reflected in the IRS's own regulations. Treas. Reg. 1.901-2(f)(1) provides:
The person by whom tax is considered paid for purposes of sections 901 and 903 is the person on whom foreign law imposes
legal liability for such tax, even if another person (e.g., a withholding agent) remits such tax.... [T]he person on whom foreign
law imposes such liability is referred to as the taxpayer.
Further, Treas. Reg. 1.901-2(f)(2) provides: Tax 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.
[7] The government makes no attempt to explain why the Old Colony principle or these regulations should not apply. See
Compaq Computer Corp. & Subsidiaries, 277 F.3d at 784 (finding economic substance based on the Old Colony principle;
the payment of Compaq's Netherlands tax obligation by Royal Dutch was income to Compaq.). Rather, it apparently asks
the Court to apply a new ad hoc theory to the STARS transactions, even if that means ignoring long established principles,
including those it has embraced in its regulations and advocated in prior cases. Those principles hold that payments between
private parties, even if they are buying and selling tax credits, are income to be accounted for on a pre-tax basis. Under those
principles, the Barclays payment is properly accounted for as pre-tax income to Sovereign, and not as a tax rebate.
*7 The government also advances a more generalized sham argument, as it did in the Bank of New York and Salem Financial
cases. Under this broad view, the whole STARS transaction was concocted to manufacture a bogus foreign tax credit for
Sovereign. There was no legitimate business purpose or economic substance to the transaction, the argument goes, except to
create the conditions under which Sovereign could claim the foreign tax credit on its U.S. returns. The courts in the other cases
apparently were persuaded to that position, but I am not. In part the argument is foreclosed by what has just been explained.
If the Barclays payment is included in the calculation of pre-tax profitability, then there was a reasonable *184 prospect of
profit as to the trust transaction, giving it economic substance. But in any event, unless the effective rebate theory is credited,
Sovereign's payment of the U.K. tax and claiming of the U.S. foreign tax credit did not produce an improper tax benefit; rather,
it was simply a wash. Even if the Barclays payment was intended to be and was the assumption of part of Sovereign's U.K. tax
burden (which Sovereign concedes for the purposes of this motion), Sovereign is nonetheless treated as having paid the full
U.K. tax for purposes of the foreign tax credit. See Treas. Reg. 1.901-2(f)(1), (2). It was thus entitled to claim the foreign
tax credit on its U.S. returns. It is true that the U.K. received an amount in taxes from Sovereign that but for the transaction
would have gone to the U.S. Treasury, but that transfer produced no advantage to Sovereign. It was still out the same amount
of tax, regardless of which country it was paid to.
One final matter. It might be suggested that the economic substance or substance over form test requires, in addition to
an assessment of the objective economic realities of a transaction, an inquiry into the subjective motivation or purpose of the
taxpayer, and that this need for a subjective inquiry raises fact issues that should preclude summary judgment. I disagree.
It is clear that cases dealing with the economic substance question always assess the objective economic reality of the
transaction to determine whether it is in actuality a legitimate or a sham transaction. Sometimes the cases also assess the
taxpayer's subjective purpose or motivation, and they often give that assessment different degrees of significance in their
ultimate judgment. Older First Circuit cases seem to emphasize reliance on objective assessment virtually to the exclusion of
subjective assessment. Stone v. C.I.R., 360 F.2d 737, 740 (1st Cir.1966); Fabreeka Prods. Co. v. C.I.R., 294 F.2d 876, 878-79
(1st Cir.1961); Granite Trust Co. v. United States, 238 F.2d 670, 678 (1st Cir.1956). Both parties try to find advantage in then-
Judge Breyer's opinion in Dewees v. C.I.R., 870 F.2d 21 (1st Cir.1989), Sovereign arguing that a close reading shows that the
court confirmed the Circuit's prior objective-only approach, the government, relying on the opinion of Judge Saylor in Fid.
Int'l Currency Advisor A Fund, LLC, 747 F.Supp.2d at 228-31, arguing that a more expansive reading indicates that Dewees
effectively (there is that word again) overruled the prior cases. I find neither position completely persuasive. The sham in
substance doctrine was not a central focus of the decision in Dewees, and my own reading of the opinion does not leave me with
the sense that the court was trying to lay out a full statement of the doctrine, either in light of the prior cases or in spite of them.
*8 If the First Circuit has occasion to address the doctrine again (as I suspect it will), I would guess that it would perhaps move
a bit away from a rigid objective only test to one that is primarily objective but has room for consideration of subjective factors
where necessary or appropriate. Nonetheless, in the circumstance where it found that the objective assessment established that
the transaction lacked economic substance independent of tax considerations, the court did say that a subjective inquiry may be
dispensed with. Dewees, 870 F.2d at 35 (Where the objective features of the situation are sufficiently clear, [the Tax Court]
has the legal power to say that self-serving statements from taxpayers could make no legal difference....). In light of that
dispensation, I would not expect it to insist on consideration of the subjective intent of a taxpayer where the transaction is
objectively judged to have had economic substance. More specifically, I have no reason to think that the First Circuit would
be inclined to follow the Sixth Circuit's proposition stated in Dow Chem. Co. v. United States, that [i]f the transaction has
economic substance, the question becomes whether the taxpayer was motivated by profit to participate in the transaction.
435 F.3d 594, 599 (6th Cir.2006) (quoting Illes v. C.I.R., 982 F.2d 163, 165 (6th Cir.1992)). [FN5] Obviously, I do not follow
that proposition here. For this reason, there is no need for a trial to conduct a subjective inquiry.
*185 For the foregoing reasons, Sovereign's motion for partial summary judgment (dkt. no. 124) has been granted.
D.Mass.,2013.
Santander Holdings USA, Inc. & Subsidiaries v. U.S. F.Supp.2d , 2013 WL 5651414 (D.Mass.), 112 A.F.T.R.2d
2013-6530, 2013-2 USTC P 50,564
*186 Not Reported in F.Supp.2d, 2013 WL 1286193 (S.D.N.Y.), 111 A.F.T.R.2d 2013-1472, 2013-1 USTC P 50,255
(Cite as: 2013 WL 1286193 (S.D.N.Y.))
Only the Westlaw citation is currently available.
United States District Court, S.D. New York. AMERICAN INTERNATIONAL GROUP,
INC., and its subsidiaries, Plaintiff, v. UNITED STATES of America, Defendant.
No. 09 Civ. 1871(LLS).
March 29, 2013.
OPINION AND ORDER
LOUIS L. STANTON, District Judge.
*1 Plaintiff American International Group, Inc., (AIG) renews its July 30, 2010 motion for partial summary judgment
that it is entitled to credits for foreign taxes paid by affiliates (Special Purpose Vehicles or SPVs) it used to effect six
transactions between AIG Financial Products Corp. (AIG-FP, a wholly-owned subsidiary of AIG) and certain overseas
financial institutions. [FN1] The Internal Revenue Service (IRS) disallowed the credits on AIG's 1997 tax return and claimed
additional amounts due in taxes, interest and penalties in a March 20, 2008 notice of deficiency. AIG paid those amounts and
now seeks an appropriate refund.
The Government claims the disallowance was proper because the transactions lack economic substance. For the reasons
which follow, the motion is denied.
BACKGROUND
From 1993 to 1997, AIG-FP entered into six transactions [FN2] structured to take advantage of the mismatch between U.S.
and foreign tax law governing agreements to sell and repurchase preferred stock. Reply at 7. AIG describes the transactions as
loans; the Government as foreign tax credit generators. Both agree that each proceeded as follows, with variations in structure
immaterial for resolution of this motion.
In each transaction, AIG-FP sold a foreign lender bank preferred shares in a foreign AIG-FP affiliate (the *187 Special
Purpose Vehicle or SPV) and committed to repurchase those shares after a term of years for the original price paid by the
lender bank.
Capitalized primarily from the sale of shares, the SPV purchased investments which generated a steady income. It paid taxes
on the investment income to its overseas tax authority and distributed much of the net proceeds to the lender.
The lender paid little, if any, tax on the distribution (dividend). Its tax authority considered the lender's purchase of preferred
stock to be an equity investment in the SPV, despite AIG-FP's obligation to repurchase the shares, and therefore treated the
SPV as the lender's corporate subsidiary, and the dividend as a tax-exempt distribution from subsidiary to parent.
On its 1997 U.S. tax return, AIG claimed foreign tax credits for the full amount of foreign tax paid by the SPV, which
exceeded AIG's U.S. tax owed on the transactions, allowing it to apply portions of the credits to its tax liability on income
from other transactions. AIG claims that under U.S. tax law, the lender's purchase of preferred stock was a loan to the SPV,
and the SPV remained AIG's corporate subsidiary, because of the repurchase obligation. Thus, AIG reported all of the SPV's
investment income, but deducted as an interest expense the dividend paid to the lender. The table below summarizes the U.S.
tax reported on AIG's 1997 return as a result of the transactions.
Tax Reported on These Transactions on AIG's 1997 U.S. Tax Return (in U.S. Dollars) [FN3]
Total Gross Income

Interest Expense

Net Taxable Income

Tax Owed

Foreign Tax Credit

Laperouse

42,646,064

23,165,617

19,480,447

6,818,156

17,769,336

Vespucci

15,798,043

8,509,043

7,289,000

2,551,150

6,582,571

NZ Issuer

43,268,472

24,701,584

18,566,888

6,498,411

14,278,596

Maitengrove

13,205,250

7,767,892

5,437,358

1,903,075

4,784,663

Lumagrove

10,641,511

6,125,265

4,516,246

1,580,686

3,830,944

Palmgrove

2,626,417

1,601,925

1,024,492

358,572

945,510

Total

128,185,757

71,871,326

56,314,431

19,710,050

48,191,620

*2 Thus, as a result of those tax effects, the parties' combined tax burden on the investment income was minimal. The foreign
tax credits claimed by AIG offset the foreign tax obligations of the SPV; the lender's dividend was tax-exempt; and AIG paid
U.S. taxes on only a portion of the investment income, having deducted much of it as an interest expense.
AIG contends the transactions were merely instances of highly profitable spread banking activity: AIG-FP borrowed funds
from each lender, purchased investments, used the return on the investments to pay the lender a suitable interest, and profited
from the difference between the interest and the return on the investments.
*188 The Government claims tax benefits generated that spread profit. According to the Government, AIG and the lender
effectively shifted tax liability from the foreign bank to the SPV, Opp. at 5, which allowed the lender to receive its return
as a tax-exempt dividend, and AIG to claim foreign tax credits and interest deductions to offset much of the foreign tax paid
by the SPV. Those tax savings permitted AIG to negotiate a dividend rate lower than the return on the investments, creating
AIG's profitable spread. Id.
Thus, the Government argues the transactions lack economic substance, i.e., they can not with reason be said to have purpose,
substance, or utility apart from their anticipated tax consequences, Lee v. Comm'r, 155 F.3d 584, 586 (2d Cir.1998) (quotation
marks omitted). AIG claims the economic substance doctrine does not apply, and that the transactions have economic substance
because they were expected to generate a pre-tax profit over the life of the transactions of at least $168.8 million. Reply at 12.
DISCUSSION
Under Federal Rule of Civil Procedure 56(a), the court shall grant summary judgment if the movant shows that there is no
genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law. This standard requires that
courts resolve all ambiguities, and credit all factual inferences that could rationally be drawn, in favor of the party opposing
summary judgment. Spinelli v. City of New York, 579 F.3d 160, 166 (2d Cir.2009) (internal quotation marks omitted).
Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which
will best pay the Treasury; there is not even a patriotic duty to increase one's taxes. Helvering v. Gregory, 69 F.2d 809, 810
(2d Cir.1934), aff'd, Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266 (1935) (The legal right of a taxpayer to decrease the
amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.).
However, even if a transaction's form matches the dictionary definitions of each term used in the statutory definition of the
tax provision, it does not follow that Congress meant to cover such a transaction and allow it a tax benefit. Altria Group, Inc.
v.. United States, 658 F.3d 276, 284 (2d Cir.2011), quoting Helvering, 69 F.2d at 810. Thus, the question for determination
is whether what was done, apart from the tax motive, was the thing which the statute intended. Gregory, 293 U.S. at 469,
55 S.Ct. at 267.
*3 The parties dispute how to determine whether what was done, apart from the tax motive, was what Congress intended
when it established the foreign tax credit.
The Government argues AIG must prove the transactions had economic substance, because Congress did not intend to confer
foreign tax credits to transactions which lack economic substance. See Ferguson v. Comm'r, 29 F.3d 98, 101 (2d Cir.1994)
(An activity will not provide the basis for deductions if it lacks economic substance.), citing Gregory, 293 U.S. at 469, 55
S. Ct at 267.
AIG argues proof of economic substance is immaterial because The purpose of the statute involved in this case is to eliminate
double taxation, and there is no dispute that disallowance of the credits at issue would subject AIG to double taxation. Reply
at 10.
As AIG states, the economic substance doctrine does not apply in every context-it only applies when the requirements that
it would impose can fairly be derived from the terms and purpose of the statute that is at issue. Id. (emphasis omitted). The
opinion in Gregory v. Helvering permits proper tax avoidance, and as to many transactions Congress has clearly intended tax
relief irrespective of the parties' motives, Diggs v. Comm'r, 281 F.2d 326, 329, or has purposely skewed the neutrality of the
system to induce activity which would otherwise result in an economic loss, Sacks v. Comm'r, 69 F.3d 982, 991 (9th Cir.1995).
To require, as the economic substance doctrine does, a taxpayer to prove a business purpose and reasonable possibility of
profit apart from tax benefits, Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir.2003), would subvert the purpose
of Congress with *189 respect to such transactions.
But those requirements are consonant with the purpose of the foreign tax credit, because Congress intended the credit to
facilitate purposive business transactions, not by subsidy, but by restoring the neutrality of the tax system.
The United States taxes the income of its citizens and residents regardless of where the income is earned. Income earned
abroad is often also subject to foreign tax. Congress passed the foreign tax credit to mitigate such double taxation of foreign
income by permitting the taxpayer to subtract the amount he pays or accrues in foreign tax from his U.S. tax bill. See, e.g.,
Kraft Gen. Foods v. Iowa Dep't of Rev. & Fin., 505 U.S. 71, 73, 112 S.Ct. 2365, 2367 (1992). Thus, the credit was originally
designed to produce uniformity of tax burden among United States taxpayers, irrespective of whether they were engaged in
business in the United States or engaged in business abroad, H.R.Rep. No. 83-1337 at 76 (1954), i.e., to neutralize the effect
of U.S. tax on the business decision of where to conduct business activities most productively, Bank of New York Mellon Corp.
v. Comm'r, 26683-09, 2013 WL 499873, at *18 (U.S. Tax Ct. Feb. 11, 2013).
*4 Motivating Congress to relieve the very severe burden, H.R.Rep. No. 65-767, at 11 (1918), on foreign income was the
need to facilitate the extension by domestic corporations of their business abroad, Burnet v. Chicago Portrait Co., 285 U.S.
1, 7-10, 52 S.Ct. 275, 277-78 (1932), and to encourage American foreign trade, Comm'r v. Am. Metal Co., 221 F.2d 134,
137 (2d Cir.1955). As stated during debate of the Revenue Act of 1918, which first established the credit:
Suppose we had a meat company over in Montreal and they would send to St. Louis a Canadian citizen from Montreal
and pay him $50,000 a year; this Government would tax him on $50,000, although he would be a British subject-a Canadian
citizen. Canada would tax him, also. Canada, no doubt, will do as we are doing by this bill-pass a law that will permit its
citizen earning an income here to deduct from his tax levied by her the amount of tax paid by him to the United States. That
is not only a just provision, but a very wise one. It is wise from the standpoint of the commerce of the United States, of the
expansion of business of the United States. There are thousands of citizens of the United States now going to South America,
and they have been going for years, and we have thousands of citizens in Canada. We would discourage men from going
out after commerce and business in different countries or residing for such purposes in different countries if we maintained
this double taxation. They would take their corporations that are American corporations and reorganize them, getting their
charters in such foreign countries, if we did not do this, and we might not be able to tax their income and profits at all. Another
thing: If we did not do that, a man would become a citizen of another country instead of retaining his citizenship here in order
to escape the large and double taxation imposed.
56 Cong. Rec.App. 677 (1918) (statement of Rep. Kitchin).
Because Congress created the foreign tax credit for the taxpayer who desires to engage in purposive activity, Goldstein v.
Comm'r, 364 F.2d 734, 742 (2d Cir.1966), and sought only to eliminate the disadvantage to his foreign business imposed by
U.S. taxation of worldwide income, it appears not to have intended the credit be available to transactions that have no economic
utility and that would not be engaged in but for the system of taxes imposed by Congress simply because the transactions
caused the taxpayer to pay foreign tax. Id. at 741.
Thus, in its claim to avoid double taxation, AIG cannot exclude consideration of the transactions' economic utility and
must show that what was done, apart from the tax benefits, is what was intended by Congress. See Compaq Computer Corp.
v. Comm'r, 277 F.3d 778 (5th Cir.2001) (applying economic substance doctrine to claim for foreign tax credits); IES Indus.
v. United States, 253 F.3d 350 (8th Cir.2001) (same); *190 Pritired 1, LLC v. United States, 816 F.Supp.2d 693 (S.D.Iowa
2011) (same); Bank of New York, 2013 WL 499873, at *16-19 (U.S. Tax Ct. Feb. 11, 2013) (same).
*5 Under the economic substance doctrine, tax benefits will be disallowed if a transaction has no business purpose or
economic effect other than the creation of tax benefits. Nicole Rose, 320 F.3d at 284.
The business purpose inquiry concerns the motives of the taxpayer in entering the transaction. Altria Group, Inc. v. United
States, 694 F.Supp.2d 259, 283 (S.D.N.Y.2010) (quoting Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89, 92 (4th Cir.1985)),
aff'd, 658 F.3d 276, 281 (2d Cir.2011).
The economic effect inquiry requires an objective determination of whether a reasonable possibility of profit from the
transaction existed apart from tax benefits, id. at 283 (internal quotation marks omitted); see Gilman v. Comm'r, 933 F.2d
143, 148 (2d Cir.1991).
AIG claims the transactions' purpose and effect was the $168.8 million pre-tax profit they were expected to obtain through
spread banking. If the computation of that figure proves correct, AIG would be entitled to judgment, because a transaction
has economic substance and will be recognized for tax purposes if it was expected to result in a significant pretax profit,
Gilman, 933 F .2d at 147, as greater weight is given to objective facts than to the taxpayer's mere statement of intent, Lee,
155 F.3d at 586.
Thus, the function of the economic substance doctrine is to distinguish the transaction which is compelled or encouraged
by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance,
Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84, 98 S.Ct. 1291, 1303 (1978), from the transaction which can not with reason be
said to have purpose, substance, or utility apart from its anticipated tax consequences, United States v. Coplan, 703 F.3d 46,
91 (2d Cir.2012), or, in this case, to determine whether AIG merely sought to minimize its tax burden on otherwise profitable
spread banking activity, or whether the spread between AIG's cost of borrowing and its return on investment existed only
because of the transactions' tax consequences, including its negotiated division of its inherent tax benefits.
To arrive at its $168.8 million figure, AIG modifies the computation of its expected return on the borrowed funds, as performed
by the Government's expert Dr. Michael Cragg, [FN4] by adding toward AIG's profit the foreign tax paid by the SPV. As a
result, AIG's figure takes the SPVs investment income, subtracts its obligations to the lender and its operating expenses, and
disregards the following; the foreign tax paid by the SPV on its investment income, the U.S. income tax paid by AIG on the
SPV's investment income, and the value of the foreign tax credits to which AIG claims it is eligible.
AIG's calculation does not, however, exclude the effects of the tax-exempt status of the lender's dividend. Because (until
AIG-FP repurchased the shares) the lender bank was considered the parent of the SPV, the SPV s transfer of funds to the bank
was tax-exempt (see p. 3 above). The lender bank shared this benefit with AIG-FP by giving AIG-FP a more favorable dividend
rate. As Mauro Gabriele, then-chief executive of AIG affiliate Banque AIG testified regarding Vespucci (involving foreign
lender BCI) and Laperouse (involving foreign lender Credit Agricole):
*191 *6 Q: Fair enough. So to what extent did the fact that BCI was receiving a dividend tax-free impact the price that
FP was going to pay?
A: Which price? The price--what do you mean by price we were willing to pay?
Q: The dividend.
A: Well, again, that was the benefit in the transaction that allowed us to raise money at a very significant sub-LIBOR
spread, because by BCI effectively receiving what were interest flows on a tax-free basis created value and that's what we
were splitting between us, ourselves.
Q: Splitting what, I'm sorry?
A: That value that was being generated by the fact that they were getting tax-exempt income for what is normally taxable
income, that was the value of the transaction.
Q: So you would talk about this tax value presumably?
A: Yes, definitely.
Q: Okay. How would those discussions go in terms of how you determine how to split it up?
A: Well, what we would say is, Okay, you're going to get tax-exempt income. So if you keep all of the value, this is
going to be the return for you in pre-tax equivalent terms. Pre-tax equivalent terms. However, we want to get benefit in
this transaction, we want to be borrowing at an attractive level so you're not going to get to keep all of that value, we're going
to keep some of it. That is what the discussion was about.
Q: All right. So how much of the benefit did you get?
A: It varied from transaction to transaction.
Q: Start with Laperouse.
A: Laperouse, I actually don't remember the actual split, to be honest. I know that I think for us it was LIBOR minus
certainly in excess of 100 basis points. I don't remember the actual number.
Q: How about--sorry, I didn't mean to cut you off.
A: I don't remember what Credit Agricole's equivalent return was. I don't know the split. In the case of Vespucci, I remember
because it was one that I did myself, BCI's return was in excess of LIBOR plus 500 and for us the borrowing was in excess
of LIBOR minus 300.
Gabriele Dep. Tr. at 98-102, attached as Ex. 22 of Decl. of John
D. Clopper.
His testimony corroborates Dr. Cragg's analysis that AIG-FP's ability to borrow' at sub-market rates was the result of
transaction terms which included AIG-FP paying the counterparties a tax-affected dividend rate. Cragg Decl. of Oct. 25, 2010
at 44. Dr. Cragg concludes that AIG-FP's cost of borrowing would have roughly equaled its return on the investment income
if the SPV's distribution had been taxable, netting no gain for AIG. Id. at 45.
For the purpose of this motion only, AIG does not contest Dr. Cragg's calculation. It asserts that as a matter of law, the tax-
exempt status of the lender's dividend is not a tax effect to be isolated and removed from the transactions in order to determine
the extent of their non-tax purpose and effect:
The solution, according to the Government, is to rewrite the terms of the transaction to remov[e] the effect of taxes on
the terms and structure of the transaction. The Government's expert, Dr. Cragg, is even more *192 explicit. He says: An
economically correct profitability analysis absent taxes adjusts all the transaction terms and returns for the impact of baked-in
tax benefits. The Government cites no case to support this entirely novel method of determining pretax profit, which would
be based not on the actual terms of the transactions but instead on a fictionalized version where all the transaction terms and
returns have been adjusted supposedly to remove the latent effects of taxes.
*7 This position incorrectly assumes that the point of the pre-tax profit analysis is to create a fictionalized world without
taxes. That is simply not correct.
2010 Reply at 26 (citations omitted) (alterations in original).
In other cases, removal of the tax impacts on a transaction might fictionalize it beyond useful analysis. But in this case,
the SPV's distribution to the bank being tax-exempt was not a trivial or speculative factor: it shaped the transactions. AIG and
its lenders considered the tax savings on the dividend to be the benefit in the transaction (Gabriele, p. 13 above), structured
the transactions to get those savings, and negotiated how to divide them. According to Dr. Cragg (and disregarding AIG's own
contribution to the SPV) AIG-FP and AIG would have enjoyed no profit from the transactions if the SPV distributions had
be en taxable.
Accordingly, AIG's motion for summary judgment in its favor cannot be granted on this record.
CONCLUSION
AIG's motion for partial summary judgment, Dkt. No. 109, is therefore denied.
So ordered.
S.D.N.Y.,2013.
American Intern. Group, Inc. v. U.S.
Not Reported in F.Supp.2d, 2013 WL 1286193 (S.D.N.Y.), 111 A.F.T.R.2d 2013-1472, 2013-1 USTC P 50,255
*193 Slip Copy, 2013 WL 7121184 (S.D.N.Y.), 112 A.F.T.R.2d 2013-7206
(Cite as: 2013 WL 7121184 (S.D.N.Y.))
United States District Court, S.D. New York. AMERICAN INTERNATIONAL GROUP,
INC., and its subsidiaries, Plaintiff, v. UNITED STATES of America, Defendant.
No. 09 Civ. 1871(LLS).
Nov. 5, 2013.
CERTIFICATION UNDER 28 U.S.C. 1292(b)
LOUIS L. STANTON, District Judge.
*1 On the letter-application of Plaintiff American International Group, Inc. (AIG), and over the opposition by defendant,
I hereby certify my March 29, 2013 Opinion and Order denying AIG's motion for partial summary judgment for interlocutory
appeal under 28 U.S.C. 1292(b).
I am well aware that Only exceptional circumstances will justify a departure from the basic policy of postponing appellate
review until after the entry of a final judgment, Klinghoffer v. S.N.C. Achille Lauro Ed Altri-Gestione Motonave Achille Lauro
in Amministrazione Straordinaria, 921 F.2d 21, 25 (2d Cir.1990), but this case presents the exceptional circumstances which
warrant interlocutory appeal. My ruling turned on two related questions of law which together are controlling, and there are
substantial grounds for difference of opinion as to each of them.
A reversal on either ground would produce judgment for AIG on the most significant of its claims in this complex (by any
standard) action.
In each transaction, AIG's subsidiary sold preferred shares in its foreign affiliate (the Special Purpose Vehicle or SPV)
to a foreign lender bank and committed to repurchase these shares in the future. The SPV invested the money from the sales,
paid taxes on the investment income to its foreign government, and made payments to the lender bank (dividend), which paid
little, if any, tax on them because the local lav/ treated the dividend as a tax-exempt intracorporate return of capital, since it
regarded the bank as an owner, not a lender. AIG in effect shared the bank's tax benefit with it, by negotiating a dividend
rate well below the return on the SPV's investments. It claims credits for the SPV's foreign tax payments, but will not obtain
those credits if the application of the economic substance doctrine bars the transactions.
I summarized the parties' positions as follows:
AIG contends the transactions were merely instances of highly profitable spread banking activity: AIG-FP [the SPV]
borrowed funds from each lender, purchased investments, used the return on the investments to pay the lender a suitable
interest, and profited from the difference between the interest and the return on the investments.
The Government claims tax benefits generated that spread profit. According to the Government, AIG and the lender
effectively shifted tax liability from the foreign bank to the affiliate, Opp. at 5, which allowed the lender to receive its
return as a tax-exempt dividend, and AIG to claim foreign tax credits and interest deductions to offset much of the foreign
tax paid by the SPV. Those tax savings permitted AIG to negotiate a dividend rate lower than the return on the investments,
creating AIG's profitable spread. Id.
Thus, the Government argues the transactions lack economic substance, i.e. they can not with reason *194 be said to have
purpose, substance, or utility apart from their anticipated tax consequences, Lee v. Comm'r, 155 F.3d 584, 586 (2d Cir.1998)
(quotation marks omitted). AIG claims that the economic substance doctrine does not apply, and that the transactions have
economic substance because they were expected to generate a pre-tax profit over the life of the transactions of at least $168.8
million. Reply at 12.
*2 American Int'l Grp., Inc. v. United States, No. 09 Civ. 1871(LLS), 2013 WL 1286193, at *2 (S.D.N.Y. Mar. 29, 2013).
I held that the economic substance doctrine (a transaction must offer a financial benefit aside from its tax advantages: not be
done for only tax purposes) should be applied to six transactions made by U.S. taxpayer AIG; and I held that the tax purposes
of those transactions shaped them because they would not otherwise result in a significant profit, and therefore any tax benefits
must be disallowed.
1.
Whether the economic substance doctrine applies is a question of law. Jacobsen v. Comm'r, 915 F.3d 832, 837 (2d Cir.1990)
(While the Tax Court's conclusion that the acquisition of Promises lacked economic substance is a finding of fact to be reviewed
for clear error, the legal standard applied by the Tax Court in making this determination is reviewed de novo.) AIG asserts that
the purpose of the foreign tax credits is to avoid double taxation, and that it would be doubly taxed if the credits were disallowed.
Preventing double taxation is a documented aim of the credits and has been recognized as the purpose of the credits by the
Supreme Court. See, e.g., United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 139 (1989) (The history of the indirect
credit clearly demonstrates that the credit was intended to protect a domestic parent from double taxation of its income.).
The record establishes that disallowance of the credits would subject AIG to taxation on the same income in both the U.S.
and a foreign jurisdiction. Thus, there are substantial grounds for ruling that the common-law disallowance doctrines (e.g., the
requirement that the transaction have economic substance) are inapplicable.
Nevertheless, I disagreed with AIG, finding that AIG cannot exclude consideration of the transactions' economic utility
and must show that what was done, apart from the tax benefits, is what was intended by Congress.' American Int'l Grp, at
*4. That determination meant that the economic substance doctrine applied and AIG had to establish a profitable purpose in
their transactions.
If the economic substance doctrine did not apply, little would be left of the Government's opposition to AIG's motion for
judgment. Alternatively, if the economic substance doctrine does apply, the issue turns to whether AIG's claim to the $268.8
million profit is sufficiently independent of the tax considerations, in which case AIG would be entitled to judgment, or rejected,
and AIG might lose six of the seven transactions, leaving only one in dispute.
2.
The transactions were structured so that the foreign government regarded the lender's purchase of preferred stock to be an
equity investment in the SPV. Thus, it treated the SPV as the lender bank's corporate subsidiary, and the dividend as a tax-
exempt intracorporate return of capital, not as interest. Because of that tax-free income, the lender bank allowed the interest
rate to be set at a lower level, allowing the SPV's investments to produce profits over the life of the transactions of upwards of
$168.8 million. If the effects of that foreign tax benefit are removed, the SPV's cost of borrowing would have roughly equaled
its return on the investment income, netting no gain for AIG and no profit from the transactions. I so held, because AIG and
its lenders considered the rax savings *195 on the dividend to be the benefit in the transaction, structured the transactions
to get those savings, and negotiated how to divide them. Id. at *7.
*3 Nevertheless, two other circuits have adopted the view that under the economic substance test, the foreign tax benefit given
to a foreign entity and shared with a U.S. taxpayer should be included in the U.S. taxpayer's profit. See Compaq v. Comm'r,
277 F.3d 778 (5th Cir.2001); IES Industries Inc. v. United States, 253 F.3d 350 (8th Cir.2001). Critical commentaries published
since my Order provide significant support for the view that this question is particularly difficult and merits appellate review.
See Jason Yen & Patrick Sigmon, District Court's AIG Ruling Expands Application of Economic Substance Doctrine in
Unexpected Ways for Transactions Generating Excess Foreign Tax Credits, Daily Tax Report (May 5, 2013) (If the decision
stands it would represent a new and significant complication for taxpayers considering transactions that generate excess foreign
tax credits or any transaction that involves tax benefits for unrelated participants); Kevin Dolan, The Foreign Tax Credit
Diaries-Litigation Run Amok, Tax Notes 907 (August 2013) (Should the U.S. borrower's pretax profit, or in this case its pretax
benefit, be reduced by the foreign tax cost as a legal matter under the economic substance's for-profit test? The answer is no,
and we have been already given that answer by two circuit courts).
3.
Immediate appeal will materially advance the ultimate termination of the litigation. It will avoid the risk of a lengthy trial on
complicated issues of tax law which might be rendered moot, if either of the challenged rulings is erroneous.
Accordingly, plaintiff's motion for certification pursuant to 1292(b) is granted.
So ordered.
S.D.N.Y.,2013.
American Intern. Group, Inc. v. U.S. Slip Copy, 2013 WL 7121184 (S.D.N.Y.), 112 A.F.T.R.2d 2013-7206
[FN1]. The acronym STARS is not particularly descriptive of the transaction at issue. There is no indication of a loan in the
acronym and there are no repackaged securities in the transaction. The evidence suggests that the concept of STARS began
as something different, and only grew to include a loan when marketed to banks in the United States.
[FN2]. In this opinion, the Court will cite to the evidentiary record as follows: February 8, 2013 Joint Stipulations--Stip.
__; Trial Testimony-- Witness name, Tr. page; Joint Exhibits--JX __ at page; Plaintiff's Exhibits-- PX __ at page; Defendant's
Exhibits __ USX __ at page; Deposition Transcripts-- Witness name, Dep. Tr. page; Demonstrative Exhibits--Demo. Ex. __.
[FN3]. These witnesses were unavailable to testify at trial because they reside outside of the United States.
[FN4]. LIBOR refers to the London InterBank Offer Rate, and is comparable to the prime rate in the United States. A
basis point is 1/100 of a percentage point.
[FN5]. Both Messrs. Monger and Watson assisted in preparing the slides presented by Mr. Reed, although they did not attend
the meeting.
[FN6]. Mr. Watson testified that BB & T would not have needed to deconsolidate InvestCo, because after the IRS challenged
the LILO and SILO transactions, the settlement with the IRS precluded BB & T from claiming tax losses arising from them.
Watson, Tr. 3517-18.
[FN7]. The Court regrets the complexity of describing the STARS transaction. Government counsel rightly observed during
his opening statement that STARS exhibits a Byzantine complexity, and in the annals of tax shelter history, there probably
has never been a more complex transaction than the STARS transaction at issue in this litigation. Donohue, Tr. 37.
[FN8]. ICTA refers to the U.K.'s Income and Corporation Taxes Act of 1988.
[FN9]. These articles, published in The Wall Street Journal and The Chicago Tribune, were titled KPMG's Emails Pointed
to Concerns Over Tax Shelters, U.S. Government Sues Sidley Austin On Tax Shelters, and Sidley Austin expels partner;
Played key role in tax shelters. Mr. Monger testified that he dismissed these articles as probably inflammatory, probably
highly erroneous, [and] obviously slanted, and observed that [a]nybody that depends on the newspaper, I think, is being rather
short-sighted. Monger, Tr. 1387.
[FN10]. See Bank of New York, 140 T.C. 15, at 46-47; Am. Int'l Grp., Inc. v. United States, No. 09-1871, 2013 WL 1286193,
*4-5 (S.D.N.Y. March 29, 2013) (AIG); Wells Fargo v. United States, No. 09-2764 (D. Minn. June 14, 2013); Pritired 1,
LLC v. United States, 816 F.Supp.2d 693, 740-41 (S.D.Iowa 2011); see also IES Indus., Inc. v. United States, 253 F.3d 350,
353-54 (8th Cir.2001); Compaq Computer Corp. v. Comm'r, 113 T.C. 214, 225 (1999).
[FN11]. When asked if two people could make a profit if I agree to give you $10 and you agree to give me $10, and we do that
repeatedly once a month for five years, Mr. Wild answered [w]e would not make a profit from doing that. Wild, Tr. 2534.
[FN12]. The Court finds it remarkable that BB & T would retain KPMG for $6.5 million in fees for tax advisory services, given
KPMG's conflict of interest in also promoting STARS on behalf of Barclays, and receiving fees from Barclays upon the closing
of each new STARS transaction. See, e.g., USX 278 at 4 (STARS is a joint venture between KPMG and Barclays.)
[FN13]. Mr. Ruble's incentive to issue favorable STARS tax opinions is further highlighted in his 2001 internal memorandum
regarding his law firm compensation package. USX 85 at 4. In this memorandum, Mr. Ruble stated I intend to continue to
exploit ties with KPMG ... in connection with the development of structured tax products. Id. He further noted that the success
of this practice is highly dependent upon the absence of anti-shelter legislation and similar IRS positions. Id.
[FN14]. Section 6662 was amended in 2004. For the years 2002 and 2003, an understatement is substantial if it exceeds the
greater of 10 percent of the tax required to be shown on the return or $10,000.
[FN15]. The 2004 amendment completely eliminated any reduction under 6662(d)(2)(B) in the case of tax shelters. See
American JobsCreation Act of 2004, Pub.L. No. 108-357, 812(d), 118 Stat. 1418, 1577-81.
[FN16]. Thus, in the situation of a tax shelter, the defenses of adequate disclosure or substantial authority (standing alone), are
insufficient to avoid the imposition of penalties.
[FN1]. Whether Barclays' maneuvers abused any U.K. tax laws is not an issue here. In any event, it appears from the record
that the U.K. tax authorities were well aware of the STARS transaction and made no objection.
[FN2]. The term bx comes from the elaborate formulae used by the parties to the transaction to calculate various values. (See,
e.g., Pl.'s Mem. in Supp. of Mot. for Partial Summ. J., Ex. 7 (dkt. no. 125-7) (Amended and Restated Formulae Letter,).)
[FN3]. Sovereign also accepts, for purposes of the motion only, that the STARS transaction can be bifurcated into trust and
loan transactions, so that the trust transaction can be evaluated without including the loan transaction. Its broader view in the
litigation is that the trust and loan components must be evaluated together.
[FN4]. There is no dispute that the U.K. tax authorities did not authorize or participate in any way in the actual calculation or
execution of the Barclays payment.
[FN5]. The Sixth Circuit's position in this respect is of dubious provenance. It traces back to a rather summary opinion in
Mahoney v. C.I.R., 808 F.2d 1219 (6th Cir.1987), which, like Dewees, was concerned with the entered into for profit language
of Code 165(c). The Mahoney court apparently thought that statutory phrase required consideration of a subjective motive.
That will not always be necessary, and perhaps even never so, in the broader, Gregory-based inquiry into economic substance.
[FN1]. In a March 29, 2011 Memorandum Endorsement (Dkt. No. 85) and in response to the Government's request for additional
discovery, I denied AIG's earlier motion without prejudice and with leave to renew, on these or other papers, following the
completion of discovery concerning the domestic transactions, i.e., a series of transactions AIG claimed to be the same, in all
material respects, to the six at issue on this motion but for their use of domestic rather than foreign affiliates of AIG. It eventually
became clear that resolution of the disputes concerning the domestic transactions would not provide a ground for decision of
this motion and would necessitate a complete analysis and ruling on the appropriate tax treatment of the domestic transactions.
Thus, with the consent of AIG and over an objection by the Government, I directed the parties to limit their discussion in the
renewed motion papers to the foreign transactions only. See Tr. of July 20, 2012 Conf. (Dkt. No. 112).
[FN2]. The names and dates of, and counterparties to, the disputed transactions are as follows: Laperouse, entered on or about
September 30, 1993 with Credit Agricole. Vespucci, on or about December 18, 1995 with Banca Commerciale Italiana. NZ
Issuer or New Zealand, December 11-19, 1996, with Bank of New Zealand. Maitengrove, on or about February 28, 1997,
with Bank of Ireland. Lumagrove, on or about August 27, 1997, with Bank of Ireland. Palmgrove, on or about October
20, 1997, with Irish Permanent.
[FN3]. All figures, except those appearing in column 4 (Tax Owed), are drawn from Figure 1 of AIG's 2010 Reply brief, at
page 12. The numbers in column 4 are 35% of the corresponding Net Taxable Income amounts appearing in column 3, and are
based on AIG's statement that it was required to-and did-pay U.S. tax on that taxable income at the standard U.S. corporate
income tax rate, which was 35%. Id.
[FN4]. The borrowed funds are the funds AIG-FP received from the lender in exchange for its preferred stock in the SPV. Those
funds provided much of the SPV's capital; the rest was provided by AIG's own contribution. AIG asserts that its pre-tax profit
would be greater if the return on its own contribution were included in its computation, but has adopted for purposes of this
motion the computations of the government's economist, Dr. Cragg. Reply at 3.
FOREIGN TAX CREDITS: PLANNING AND PITFALLS, VCVG0919 ALI-CLE 1
VCVG0919 ALI-ABA 1
February 26, 2014
*1 FOREIGN TAX CREDITS: PLANNING AND PITFALLS
Richard E. Andersen [FNa1]
WilmerHale
New York, New York
Jerald David August
Fox Rothschild LLP
Copyright (c) 2014 The American Law Institute; Richard E. Andersen and Jerald David August
*2 TABLE OF CONTENTS
I. INTRODUCTION
A. Worldwide System of Income Taxation Versus Territorial Based System of Income Taxation
1. Jurisdiction to Tax
2. Territorial Based System
3. Residence Based System
a. Mitigation of Double Taxation Under World-Wide System of Taxation: Foreign Tax Credits
b. Limitation on Current Use of Excess Foreign Tax Credits
4. Based Systems of Income Taxation
5. Impact of Tax Treaties
B. Purpose of the Foreign Tax Credit
C. The Foreign Tax Credit in Action: A Hypothetical Case
1. Facts
2. Credit Example
3. Deduction Example
4. Claiming The Credit or Taking the Deduction
a. Annual Election
b. Preference for Foreign Tax Credit Over Deduction for Foreign Taxes
c. Election Mechanics
d. Statute of Limitations for Foreign Tax Credits
e. Limitation on Use of Deconsolidation to Avoid Foreign Tax Credit Limitations
*3 D. History of the Credit
1. Introduction of the FTC
2. Principal Amendments to the FTC Provisions Prior to the American Jobs Protection Act of 2004, P.L.
a. Limitations of FTCs (No Cross-crediting Allowed)
b. Revenue Act of 1962
c. Tax Reform Act of 1976
d. Taxpayer Relief Act of 1997
e. Amendments Impacting the Foreign Tax Credit Rules Under the American Jobs Creation Act of 2004 (AJCA
2004)
(1) Reduction in FTC Limitation Baskets
(2) Dividends From a 10/50 Corporation
(3) Change in Overall Foreign and Domestic Loss Rules
(4) Foreign Tax Credits Paid by Partnerships Having Domestic Partners
(5) Direct Foreign Tax Credits per Section 901
(6) Foreign Tax Credit Carryover Periods
(7) Repeal of Foreign Tax Credit Limitation on Alternative Minimum Tax
(8) Anti-FTC Shopping Provision
(9) New Method for Allocating Interest Expense for FTC Purposes
f. Education Jobs and Medicaid Assistance Act of 2010 (P.L. 111-226)
g. American Taxpayer Relief Act of 2012 (P.L.112-240)
E. Current Principles of the Credit
1. Fundamental Objectives of the FTC
*4 2. Foreign Income Tax on Foreign Source Income
3. Primacy of U.S. Tax and Legal Principles
II. CREDITABLE TAXES
A. Tax Requirement
1. Imposed by a Foreign Country or U.S. Possession
2. Definition of Foreign Country or U.S. Possession
3. Indirect Payment to Foreign Government Sufficient
4. Tax on Business Revenues Distinguished From Taxes on Income or In Lieu of Income Tax
a. In General
b. Receipt of Economic Benefit
c. In Lieu of Taxes: Section 903
5. U.K. Windfall Profits Tax Held Creditable by United States Supreme Court
6. Disqualifying Effect of Subsidies
7. Payment of Subsidy To Another Person
8. Soak-Up Taxes
9. Service's Attack on So-Called Foreign Tax Credit Generators
10. SPIA Proposed and Temporary Regulations: Service's Response to FTC Generators
11. SPIA Final Regulations
B. Tax on Income Requirement
1. Realization
2. Gross Receipts
3. Net Income
4. PPL Corp
*5 III. THE DIRECT CREDIT
A. In General
B. Paid or Accrued Requirement
C. Technical Taxpayer Requirement
1. Section 901(b): Persons Eligible for Foreign Tax Credits
a. Taxpayer Must be Liable for the Foreign Tax
b. Application to Corporations
2. Indirect Payment of Foreign Taxes
3. Proportionate Share of Foreign Taxes of a Partner in a Partnership
4. Matching Foreign Source Income and Foreign Taxes
5. Non-residents' Ability to Claim Foreign Tax Credits: Section 906
a. Tax Must be Imposed on the Recipient
b. Application to Foreign Disregarded Entity
(1) Court of Federal Claims Decision
(2) Appeal to the Federal Circuit
(3) Issuance of Regulations and Later Congressional Action in Enacting Section 909
IV. THE INDIRECT FOREIGN TAX CREDIT
A. Background
1. In General
2. Indirect Credit Example
B. Requirements for the Indirect Credit
1. Corporate Recipient
a. Pass Through Eligible Entities
b. Six Tier Subsidiary Limitation
c. Allocation and Apportionment of Interest Expense
*6 2. Interest in Foreign Taxpaying Corporation
3. Dividend
a. Payment of Actual Dividends
b. Dividend Analogues and Constructive Dividends
(1) Subpart F Inclusions: Sections 960 and 962
(2) Section 1291 Deferral Rules and Indirect Foreign Tax Credits
(3) Section 1293 Current Income Inclusions and Foreign Tax Credits
(4) Application to Domestic International Sales Corporations (DISC)
c. Application of Section 902 and Section 1248
d. Application of Section 902 and Section 367
e. Sales Recharacterized as Dividends
(1) Section 302 Redemptions
(2) Section 304 Redemptions or Sales
(3) Section 1248 Dispositions
V. THE SECTION 904 LIMITATION
A. Purpose of the Section 904 Limitation
B. Overview of the Baskets
C. The Limitation in Action: A Hypothetical Case
D. Current Principles of the Limitation
E. Determining the Baskets
1. Pre-2007 Tax Years (Before AJCA 2004 Amendments)
a. Passive Income
b. High Withholding Tax Interest
*7 c. Financial Services Income
d. Shipping Income
e. Dividends Received From Noncontrolled Section 902 Corporations
(1) First (Pre-2003) Rules
(2) Second (Post-2002) Rules
f. Dividends from DISCs and Former DISCs
g. Distributions from FSCs and Former FSCs
h. Foreign Trade Income
i. Other Income
j. Look-Through Rules
k. Other Operating Rules
2. Post-2006 Tax Years (After AJCA 2004 Amendments)
a. Passive Category Income
b. General Category Income
F. Calculating the Foreign Source Taxable Income-Domestic Taxable Income Ratios
VI. SERVICE'S ATTACK ON FOREIGN TAX GENERATORS: WHAT IS THE PROPER APPLICATION OF THE
ECONOMIC SUBSTANCE DOCTRINE TO FOREIGN TAX CREDITS
A. Application of the Economic Substance Doctrine to Federal Tax Credit Planning
1. Fundamental Principle of Federal Income Tax Law
a. Business Purpose Doctrine
b. Economic Substance Doctrine
c. Satisfaction of Either Business Purpose or Economic Substance Tests or Both?
2. Codification in Section 7701(o)
*8 a. Penalties
b. Impact of Section 7701(o) on Mainstream Business Transactions
3. Foreign Tax Credit Cases Involving Economic Substance and Business Purpose Doctrines
a. Foreign Tax Credit Generators: Background
(1) Scenario One: Foreign Subsidiary of U.S. Parent Corporation
(2) Scenario Two: The Newly Formed Subsidiary
(3) Example
b. Compaq Computer Corp. v. Comm'r
(1) Factual Setting
(2) American Depositary Receipt or ADR
(3) Challenge by IRS
(4) Tax Court Decision
(5) The Fifth Circuit Court of Appeals reverses the Tax Court
c. Hewlett-Packard Company v. Comm,r
(1) Facts
(2) Taxpayer's Reporting Position
(3) Service's Notice of Deficiency
(4) Tax Court Memorandum Decision, Judge Goeke
d. Bank of New York Mellon Corporation v. Comm'r
(1) Facts
(2) Tax Court Decision: Still Relying on Compaq Computer
e. American International Group. Inc. v. United States, 111 AFTR2d 2013-1472 (DC NY, 2013)
*9 (1) Facts
(2) IRS Challenge
(3) District Court Sides With United States
f. Pritired 1. LLC v. United States, 108 AFTR2d 2011-6605 (DC IA 2011)
(1) Facts
(2) IRS Challenge; Refund Suit
(3) Decision of District Court for Government
B. Treasury and Internal Revenue Service Respond to Passive Income Generator Problem
1. Final and Temporary Regulations to Section 901 On Foreign Tax Generators Amending, in Particular Treas. Reg.
1.902-2(e)
a. Treatment of Amounts Attributable to a Structured Passive Investment Arrangement
b. The Special Purpose Vehicles Condition
(1) Substantially All Passive Investment Income
(2) Income Attributable To Foreign Entity
c. Revision to Holding Company Exception to Transactions Involving Multiple Counterparties or Multiple U.S. Parties
(1) Definition of U.S. Party
d. Required Direct Investment Condition
e. Foreign Tax Benefit Condition
f. Counterparty Condition
g. Dual Citizens or U.S. Residents
h. Family Members
i. Compensation Stock
j. Application To Non-Related U.S. Party
*10 k. Inconsistent Treatment Condition
VII. FOREIGN TAX SPLITTER PROVISIONS. EDUCATION JOBS AND MEDICAID ASSISTANCE ACT OF 2010
(P.L. 111-226); FINAL REGULATIONS TO THE TAX SPLITTER PROVISIONS AND THE TECHNICAL TAXPAYER
RULES
A. Overview of Section 909
B. Proposed Regulations To the Technical Taxpayer Rules Issued by Service in 2006 After Its Loss in Guardian Industries,
supra
1. Who Is the Technical Taxpayer?
2. Foreign Consolidated Groups: Reversing the Guardian Result
3. Treatment of Hybrid Entities
4. Final and Temporary Regulations to Legal Liability Rule in Treas. Reg. 1.901-2(f)(4)
5. Yielded to Section 909
C. Committee Report Explanation on Section 909
1. In General
2. Section 909 Applies At Partner, S Corp. Shareholder or Beneficiary Level
3. The Trigger: A Foreign Tax Credit Splitting Event
4. Concept of a Covered Person
5. Suspension of FTCs Not Currently Taken Into Account Due to Matching Rule in Section 909
6. Authority to Issue Legislative Regulations. Other Guidance
7. Example of FTC Splitter
8. Effective Date of Section 909
D. General Principles of Section 909 And Related Guidance
1. Strict Matching Approach Adopted in Section 909
2. Foreign Tax Splitting Event
*11 3. Covered Persons
4. Related Income
5. Indirect Foreign Tax Credits and Section 909
6. FTC Splitter Rules and Partnerships, S Corporations and Trusts
7. Notice 2010-92. 2010-52 I.R.B. 916
a. Reverse Hybrid Structures Involving Section 902 Corporation
b. Certain Foreign Consolidated Groups As a Pre-2011 Splitter Arrangement
c. Group Relief and Other Loss-Sharing Regimes
d. Hybrid Instruments
8. Final Regulations Issued under Section 901 (TD 9576 . 2/8/12)
a. Combined Basis Reporting of FTCs
b. Fiscally Transparent Entity
c. Reverse Hybrid Entity
d. Share of Combined (Foreign Tax) Income Base
(1) 2006 Proposed Regulations
(2) Final Regulations to Section 901 (2012)
e. Payment By Related Party of Another Person's Foreign Tax
(1) Proposed Regulations (2006) Treatment
(2) Final Regulations to Section 901 (2012)
f. Foreign Taxes Imposed On Partnerships and Disregarded Entities
(1) Proposed Regulations (2006)
(2) Final Regulations (2012)
9. Temporary Regulations Issued in 2012 Under Section 909
*12 a. Splitter Events Identified
b. Related Income and Split Taxes
c. Similarity With Rules Contained in Notice 2010-92, supra
d. Effective Date of Temporary Regulations to Section 909
e. Non-Application to Covered Asset Acquisitions in Section 901(m)
(1) Section 901(m)
(2) Section 909 Temporary Regulations (2012)
f. Identification in 2012 Temporary Regulations to Splitter-Events
(1) Reverse hybrid splitter arrangements
(2) Loss-sharing splitter arrangements
(3) Hybrid instrument splitter arrangements
(4) Partnership inter-branch payment splitter arrangements
g. Future Guidance on Section 909
h. Temp. Regs. 1.909-1T(b) and (c)
(1) Reconciling the Temporary Regulations to Section 909 and Notice 2012-92, and in particular, 4.06 of Notice
2010-92
VIII. OTHER SPECIAL LIMITATIONS
A. Oil and Gas Income
1. Background
2. FOGEI
3. FORI
B. Alternative Minimum Tax
C. Step-Up Acquisitions
*13 IX. PROCEDURAL ISSUES
A. Forms
B. Carryback/Carryforward of Excess Foreign Tax Credits
C. Subsequent Adjustments
D. Limitations Period
*14 Foreign Tax Credits: Planning and Pitfalls
By: Richard E. Andersen and Jerald David August
I. INTRODUCTION
A. Worldwide System of Income Taxation Versus Territorial Based System of Income Taxation.
1. Jurisdiction to Tax. A sovereign nation, as a fundamental principal of international law, has the right or jurisdiction
to tax income that is economically related to it. There are two basic models in which this principle is promulgated into
law: (i) an income tax system based on nationality or citizenship (a residence based system); or (ii) an income tax system
based on the source of income (a territorial based system). While nationality is usually referred to as citizenship, nearly
all of the countries in the world (with the exception of the U.S.) have adopted a wider definition of nationality for tax
purposes, i.e., residency.
Under the Internal Revenue Code (26 U.S.C. 7702(b)) a non-U.S. citizen is a U.S. resident if such person is issued,
by INS, a green card under U.S. immigration laws and is entitled to work in the United States, as well as most people
who reside in the United States for more than a minimum period (Treas. Reg. 301.7701(b)-2), disregarding certain classes
of people, e.g., foreign diplomats and individuals receiving medical help (See Treas. Reg. 301.7701(b)-8; Form 8843
(Statement for Exempt Individuals and Individuals With a Medical Condition)).
Under the substantial presence test, a non-U.S. citizen who has not been issued a permanent resident visa, may stay or
reside in the United States for an average of up to 121 days per year if such individual does not have a tax home abroad
(based on a weighted three year average), and up to 182 days per year where such individual maintains a tax home (closer
connection exception) in his or her home country. The term tax home means the taxpayer's regular place of business, or if
he has several such places, the principal place of business. Treas. Reg. 301.7701(b)-2(c)(l). Defining closer connection
depends on comparing significant contacts, such as the location of the taxpayer's permanent home, family, personal
belongings, and personal bank accounts; the location of social, political, cultural, and religious organizations with which
he has a relationship; the country where he holds a driver's license or votes; and the country of residence that he claims on
documents that he files returns. Treas. Reg. 301.7701(b)-2(d). Tax treaties maintain a residence tiebreaker provision in
resolving potential dual-residence issues. See 1996 U.S. Model Treaty, art. 4(2); 1981 U.S. Model Treaty, art. (4)(2). See
Treasury Department, Approaches to Improve the Competitiveness of the *15 U.S. Business Tax System for the 21st
Century, 55 (Dec. 20, 2007) (hereinafter Treasury, Approaches), Doc 2007-27866, 2007 WTD 246-25 Hugh J. Ault
and Brian J. Arnold, Comparative Income Taxation 345 (2d ed. 2004); Stephen E. Shay, J. Clifton Fleming Jr., and Robert
J. Peroni, The David R. Tillinghast Lecture: What's Source Got to Do With It? Source Rules and U.S. International
Taxation, 56 Tax L. Rev. 81, 83-106 (2002); Avi-Yonah, International Tax as International Law, 22, 27 (2007).
2. Territorial Based System. Under the territorial based taxation system, a sovereign country imposes income (or other
forms of) taxes on economic activity originating within its borders, regardless of whether it is generated by its residents or
by nonresidents. It is the jurisdiction where the wealth is produced that serves as the underlying rationale for the territorial
based system of income taxation. In its most narrow form, i.e., a pure territorial or exemption based system, the residence
country imposes no income tax on its residents' foreign-source business income. This result follows by allowing corporate
residents an exemption for both foreign branch income and for dividends received from foreign corporations in which
a corporate resident owns a substantial stock interest (often referred to as non-portfolio dividends). Under the territorial
based system, foreign-source business income is only taxed by the source country.
3. Residence Based System. Under a residence based taxation system, a country imposes income tax on income derived
by its residents without regard to whether the physical location or origin of that income is within the territorial borders of
the country. The underlying rationale supporting this world-wide approach is based on where the income is generated from
the particular business or investment activity is consumed or otherwise disposed of. See League of Nations--Economic
and Financial Commission, Report on Double Taxation, 23 (1923); Prussak, Online Advertising: The Implications of
Technology for Source-Based Taxation, Tax Notes International, (8/12/2013). In a pure model system of worldwide
taxation, the country of a taxpayer's residence subjects the resident's entire foreign-source income to income taxation when
the income is earned. Of course, that same income is also taxed by the foreign country where it originated (the source
country).
a. Mitigation of Double Taxation Under World-Wide System of Taxation: Foreign Tax Credits. In order to mitigate
the impact of double taxation, the residence country system credits the source-country tax against the residence-country
tax (the foreign tax credit (or deduction) or FTC).
b. Limitation on Current Use of Excess Foreign Tax Credits. Where the amount of FTC's potentially allowable, i.e.,
foreign taxes paid or accrued on foreign source income, are in excess of the residence *16 country tax on foreign-
source income, the excess foreign taxes would effectively reduce the residence country tax on residence country domestic
income. Reducing domestic source income by excess FTCs would do more than eliminate double taxation, it would
essentially grant the resident taxpayer to a tax credit or subsidy for activity that produced the foreign-source income. As
contained in 904 (26 U.S.C.), the residence country usually limits its FTC to the amount of residence country tax on such
foreign-source income. Where the source country is a low-tax or tax-haven jurisdiction compared with the applicable tax
rate imposed by the residence country, a worldwide system allows the residence country to collect a residual tax equal
to the amount by which the residence-country tax exceeds the source-country tax. The basic 904(a) limitation is set forth
as a fraction: U.S. taxes (before credits), multiplied by foreign-source taxable income (numerator) over total (worldwide)
taxable income (denominator). The effect of this annually computed limitation is that foreign-source income is taxed at
the higher of the U.S. or foreign effective rate. However, where the foreign rate is greater, the excess is not immediately
creditable but may be used in a subsequent year as a carryover FTC. Obviously, the greater the FTC limitation numerator,
the greater the opportunity to currently claim FTCs. See 904(c) and supporting regulations.
4. Based Systems of Income Taxation. Many countries have adopted a tax system combining both territorial and
residence income tax based principles. For example, the United States has adopted a residence-based system for imposing
income tax on income derived by its residents, and a territorial based system for income derived by nonresidents
on passive sources of investment income and income that is not effectively connected with or deemed effectively
connected with the conduct of a U.S. trade or business. Accordingly, U.S. residents, as defined in Sections 7701(a)
(3) and 7701(b), are taxed by the U.S. on income derived worldwide, while non-U.S. residents are taxed by the U.S.
only on income derived from sources within the U.S. A flat 30% (or lower treaty) tax rate applies to U.S.-source
income passive type income items described in 871(a) received by nonresident aliens (and foreign corporations under
881(a)) to the extent the items are included in gross income. The U.S.-source income items subject to the 30% tax
include interest (but there are exceptions which exclude certain passive forms of U.S. source interest from taxation
in the form of bank deposit interest, portfolio interest and certain short-term obligations and the limit on original
issue discount (OID)) dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments,
and other fixed or determinable annual or periodical (FDAP) gains, profits, and income. Other countries, including the
United Kingdom, Canada, and Japan, have adopted a different set of applicable rules in arriving at a hybrid model
of territorial-based and residence-based *17 systems. Under such tax systems, some types of income generated by a
resident from foreign sources will be exempt (based on the territorial or source limitation model) while other types
of income, usually passive income, will be taxed (based on the residence principle). There are proposals outstanding
for reforming the Internal Revenue Code to adopt principles of territoriality to U.S. residents. Compare, White House
and the Department of the Treasury, The President's Framework for Business Tax Reform, http://www.treasury.gov/
resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax0Reform-02-22-2012.pdf with U.S.
Congress--Committee on Ways and Means, Technical Explanation of the Ways and Means discussion Draft Provisions
to Establish a Participation Exemption System for the Taxation of Foreign Income: http:// waysandmeans.house.gov/
UploadedFiles/FINAL_TE_Ways_and_Means_Participation_ Exemption_Discussion_Draft.pdf
5. Impact of Tax Treaties. U.S. income tax treaties include provisions concerning the use of FTCs. In general, the tax
treaties do not grant additional credits in addition to those provided under the Internal Revenue Code. Still, some treaties
make certain levies creditable where such levies that might not be considered income taxes in full under the Code
and regulations. See, e.g., U.S.-Norway Income Tax Treaty, Art. 23(1); Article 24(4)(a) and 24(4)(b) of the 2001 U.S.-
U.K. Treaty; see also Rev. Rul. 2002-16, 2002-1 C.B. 740 (Netherlands tax on imputed income is creditable under the
U.S.-Netherlands Income Tax Treaty because it is part of a new income tax that is substantially similar to a tax covered
by the treaty). Taxpayers claiming a credit for a tax made creditable by a treaty must file Form 8833. Treas. Reg.
301.7701(b)-7(b), 301.7701(b)-7(c)(1). The statement is made by including Form 8833 (Treaty-Based Return Position
Disclosure under Section 6114 or Section 7701(b)) with Form 1040NR. See Proc. Reg. 301.6114-1 (b)(7).
In addition, the particular provisions of an income tax treaty can affect FTCs that may be used by U.S. persons by
modifying the source rules in the Internal Revenue Code (and, thereby, the amount of a person's foreign-source income) for
purposes of determining the applicable foreign tax credit limitations under 904 and 907. For example, under the U.S.-
Canada income tax treaty, certain U.S.-source income derived by U.S. citizens resident in Canada is treated as Canadian-
source income in order to allow such persons to claim (U.S.) FTCs for Canadian taxes imposed on the basis of Canadian
residency. U.S.-Canada Income Tax Treaty, Art. XXIV(6)(permits limited resourcing of income to avoid double taxation).
Some treaties have special creditability and/or sourcing provisions which apply special (e.g., per-country) limitations to
taxpayers who avail themselves of those provisions. In addition, 904(h)(10) and 865(h)(gains from sale of certain stock
or intangibles and from certain *18 liquidations) provide that a separate limitation must be computed for certain income
sourced under a treaty obligation of the United States. Section 904(h)(10) allows a taxpayer to resolve a conflict between a
U.S. treaty and the source rules of 904(g)(l). The taxpayer may elect to have the source rules of 904(g) not apply. In such
instance, 904(a), (b) and (c) are applied separately to the each species of income. See Treas. Reg. 1.904-5(m)(7). Section
865(h) also contains a parallel set of rules regarding the source of income from the sale of a foreign corporation's stock or
of certain intangible property. Where applicable, a taxpayer may elect to have foreign-source income determined under the
rules of a treaty. Section 865(h)(1) isolates the benefit, however, by requiring 904(a), (b) and (c) to be applied separately.
Double taxation of U.S. persons is also alleviated in limited cases through the operation of reciprocal exemptions of profits
contained in statutory law or in tax treaties, whereby one jurisdiction cedes its right to tax. See, e.g., 872(b) and 883.
B. Purpose of the Foreign Tax Credit.
Without significant exception, the major trading partners of the United States tax foreign companies on the profits derived
from operations conducted within those countries' borders. The United States taxes domestic entities on their worldwide
profits. Consequently, the possibility exists for double taxation - the same item of income being taxed once by the source
country and again by the United States. If left uncorrected, this situation would produce a substantial competitive disadvantage
for U.S. companies doing business overseas, since their foreign owned territorial system competitors would currently bear
only a single level of tax on the same business profits. Moreover, the foreign tax credit permits U.S. companies or taxpayers
the ability to compete on a more level playing field with residents of territorial based system jurisdictions with respect to
foreign-source business income.
In an attempt to eliminate this disadvantage for U.S. multinationals, the United States has adopted statutory provisions to
mitigate the risk of double taxation on foreign profits. As mentioned previously, the mechanism selected to accomplish this
result is the foreign tax credit (FTC). Simply stated, the FTC in its pure form is a dollar-for-dollar reduction in the U.S.
federal income tax otherwise imposed on the overseas profits of U.S. multinational taxpayers. See 901, 902, 903, 904, 960.
Although foreign income taxes are generally deductible against U.S. income ( 164(a)(3)), the FTC is substantially more
valuable in most cases than an income tax deduction since the latter merely reduces the amount of foreign source income
subject to tax instead of achieving a dollar-for-dollar offset. The United States also allows a foreign tax credit to foreign
persons with respect to their income effectively connected with the conduct of a trade or business in the United States.
Before a U.S. taxpayer may claim a FTC, there are rules of limitation and other conditions contained in the Code, regulations
and case law. See, e.g., 901, *19 902, and 904 and corresponding regulations. As to consolidated returns, special rules
apply. See Treas. Regs. 1.1502-4 and -9. An overall limitation on the current use of FTCs, as explained above, is contained
in 904(a). This limits the otherwise allowable FTCs by multiplying the pre-credit U.S. tax by a fraction, the numerator is
foreign source taxable income and the denominator is worldwide taxable income. A second limitation on the current use of
FTCs is found in 904(d). Under 904(d), the potentially allowable FTCs are allocated to separate categories or baskets of
income which rule, in general, is designed to prevent the blending of foreign tax rates on different types of income.
The FTC may take the form of either a direct credit by the taxpayer for reporting on such person's income tax return,
or, for domestic corporations owning a certain percentage (10% or more) of voting stock in a foreign corporation subject
to foreign taxes, an indirect credit. See 901, 902, 960. A direct FTC may be claimed for certain foreign taxes paid or
accrued to a foreign country or U.S. possession (e.g., foreign withholding tax). 901. Additionally, a direct credit may be
available when the taxpayer owns an interest in an entity that is a flow-through entity (e.g., a partnership or hybrid entity
that is treated as a disregarded entity or partnership for U.S. federal income tax purposes). Again, an indirect credit may be
claimed on dividends received by a domestic corporation that owns 10% or more of the voting stock of a foreign corporation
or constructive dividends on subpart F income from a controlled foreign corporation. See 902, 960(a)(1), 962.
C. The Foreign Tax Credit in Action: A Hypothetical Case.
1. Facts. USCO is a profitable domestic corporation, subject to a 35% U.S. federal income tax rate on its world-wide
income, engaged in the manufacture and sale of widgets in the United States and overseas. In a given taxable year, e.g.,
2013, it earns $500x in net pre-tax profit from U.S. sales of its inventory. It also earns $300x in net pre-tax profit from sales
within Country Z, which taxes corporate profits at a flat 33-#% rate. USCO has no other income or expenses anywhere for
the year, and has no loss or tax credit carryforwards to that year.
2. Credit Example. USCO is subject to a final U.S. federal income tax of $175x on its U.S. profits ($500x * 35%). It
is also subject to a tentative U.S. federal income tax of $105x on its Country Z profits ($300x * 35%), on which it also
owes $100x of Country Z income tax ($300x *33-#%). If USCO elects to claim the FTC under 901 in lieu of claiming a
deduction under 164, the tentative U.S. federal income tax on USCO's Country Z profits is reduced by the actual Country
Z income tax paid on those profits, leaving only $5x of final U.S. federal income tax liability on account of those profits
($105x - $100x). USCO's total U.S. federal income tax liability for 2013 is thus $180x, an effective U.S. federal income
tax rate of approximately 22.5% ($180x * $800x * 100%). Note that its worldwide effective tax rate is 35% ($280 x:
$800x * 100%), *20 which is the higher of the U.S. or Country Z effective rates; the credit system generally results in
the U.S. taxpayer (corporate as in the hypothetical or resident individual) paying the higher of the U.S. or foreign tax rates
on its foreign source income.
3. Deduction Example. If USCO does not choose to claim the FTC, but instead deducts its Country Z taxes under 164, it
is still subject to a final U.S. federal income tax of $175x on its U.S. source profits ($500x *35%). USCO deducts the $100x
of Country Z taxes paid from its $300x of income derived from Country Z sales, and is subject to $70x of additional tax
on the remaining $200x of such income. USCO's total U.S. federal income tax liability for 2013 is $245x, which yields an
effective rate of approximately 30.63% (over 8 percentage points higher than in the credit example above). (This example
assumes that the Country Z tax deduction is wholly attributable to USCO's Country Z profits, which is not always the case).
4. Claiming The Credit or Taking the Deduction.
a. Annual Election. The election to credit rather than deduct foreign taxes is, in general, an annual election that applies
to all foreign taxes paid or accrued in that year. Under 905(a) the election by a cash basis taxpayer to claim FTCs on an
accrual basis is not part of the annual election provision. Once the accrual method claim for FTCs is made by a cash basis
taxpayer, the 905(a) election is irrevocable. See 905(c)(2)(special rules for taxes accrued but unpaid after 2 years).
Amendments to the 905(c) Temporary Regulations (TD 9362, 11/6/07; the 2007 Temporary Regulations) provide for
certain adjustments where there has been a foreign tax redetermination, i.e., a change in the foreign tax liability that
may affect the taxpayer's foreign tax credit. The taxpayer generally must file an amended return for the affected year(s)
if, as a result of the foreign tax change, a redetermination of the taxpayer's U.S. tax liability is required.
b. Preference for Foreign Tax Credit Over Deduction for Foreign Taxes. Generally, for U.S. taxpayers, the FTC is
significantly more preferable over the deduction approach as it reduces worldwide income taxes on a dollar-for-dollar
basis, subject to application limitation. There may be certain instances where, based on the taxpayer's particular tax
attributes, the deduction may generate greater tax savings. One example of the latter instance may occur is in an excess
FTC position, i.e., where foreign taxes exceed foreign income caused as a result of tax base or sourcing differences.
While sacrificing the use of excess FTC carryovers in other taxable years, a deduction over credit approach may be
preferable where foreign taxes exceed foreign income since the *21 additional foreign tax deductions will reduce
taxable U.S. source income. Deducting foreign taxes may also be more beneficial when the taxpayer has a loss for the
year (considering income from both U.S. and foreign sources). In that circumstance, the taxpayer has no pre-credit U.S.
tax liability against which to claim a foreign tax credit. While again giving up the FTC carryovers, the taxpayer may
prefer deducting foreign taxes in a year in which it has a loss, because the deduction may increase the taxpayer's NOL
for 172 purposes and yield a NOL carryback or carryforward.
c. Election Mechanics. The election to credit or deduct foreign taxes is made by attaching the appropriate form to
the taxpayer's annual return. The form for individuals claiming the foreign tax credit is the Form 1116. Individuals that
pay less than $300 of foreign taxes (or $600 in the case of a joint return) may not have to file a Form 1116 in certain
circumstances. See 904(j). The form for corporations claiming the foreign tax credit is the Form 1118. It is important
to note that with respect to any single year, a taxpayer must credit or deduct all foreign taxes paid or accrued during
that year. Treas. Reg. 1.901-1(c).
d. Statute of Limitations for Foreign Tax Credits. Section 6511(d)(3) extends the normal three-year statute of
limitations for refund claims for overpayments of tax, to 10 years in the case of refund claims based on the availability
of foreign tax credits. Treas. Reg. 1.901-1(d). The 10 year statute runs from the year in which the taxes, that are sought
to have been overpaid by aid of hindsight, were paid or accrued. See CCAs 201136021 and 20111009. Where the FTC
election is changed, i.e., reduced, and such change results in additional tax liability in earlier years, statutory interest
presumably will be due from the due dates for timely filing returns from such prior years.
In General Dynamics Corp v. U.S.. 562 F.2d 1201 (Ct. Cl. 1977), the corporate taxpayer, on its 1958 and 1959 federal
income tax returns, claimed FTCs in computing its federal income tax liability. Subsequently, a NOL loss carryback
from its 1961 tax year eliminated all plaintiffs federal tax liability for 1958 and 1959, without use of the FTCs. Due to
the FTC limitation under 904(d), Dynamics was unable to use FTCs for 1958 and 1959. It therefore timely claimed
to elect deductions for the foreign taxes paid in such years rather than FTCs. The effect of General Dynamics' choice
to deduct rather than credit foreign taxes reduced portions of the 1961 loss carryback absorbed by plaintiffs taxable
income for 1958 and 1959, and therefore increased the amount of the loss available to be carried to other taxable years.
Had Dynamics originally elected to deduct the foreign taxes, the effect would have *22 been to increase plaintiff's
federal tax liability (before taking into account the 1961 loss carryback) by the amounts of $1,161,820.03 for 1958, and
$1,795,903.61 for 1959. After audit by the IRS, interest was assessed and paid by taxpayer upon these amounts, 8 from
the due dates of the 1958 and 1959 returns to December 31, 1961, the date when the loss carryback arose. For 1958,
interest assessed (and paid) was $207,383.62; for 1959, the amount was $431,349.13. The IRS does not assert a right
to the deficiencies per se in plaintiff's 1958 and 1959 federal tax liability found when the foreign taxes paid were taken
as deductions. The deficiencies were properly and completely eliminated by the application of the 1961 loss carryback
to plaintiffs 1958 and 1959 tax liability. At issue is whether interest was properly assessed. Dynamics paid the interest
and then brought a refund suit claiming that since there were no deficiencies in its 1958 and 1959 federal tax returns
prior to the existence of the 1961 NOL carryback, it should not have to pay interest on deficiencies arising after the 1961
carryback because the deficiencies were both caused and eliminated by the carryback (and the accompanying election
to deduct foreign taxes). In other words, Dynamics argued that because it never owed the deficiencies for either year
under either the originally filed return computation or the NOL carryback computation, but after taking into account the
carryback for 1961, it should not have to pay interest. The IRS argued that interest was required to be assessed inasmuch
as Dynamic's final choice to deduct foreign taxes was determinative of tax liability. The Court of Claims Court rejected
the taxpayer's argument and held that the taxpayer owed interest on tax for the carryback years calculated as if the FTC
had never been claimed. See also 904(i)(treats related but non-consolidated corporations as if they were members of
a consolidated group for certain FTC purposes).
e. Limitation on Use of Deconsolidation to Avoid Foreign Tax Credit Limitations. In order to prevent taxpayers from
interposing non-includible corporations within an affiliated group in order to avoid the application of the 904 limitation,
Congress enacted Section 904(i). Section 904(i) applies when two or more deconsolidated domestic corporations would
be deemed to be members of an affiliated group 1504(b) were disregarded and the constructive ownership rules of
1563(e) were applied. Section 904(i)(l) treats every group of corporations connected through the 80% stock ownership
as provided in 1504 as an affiliated group. The constructive stock rules of 1563(e) permits the aggregation of related
parties to meet that ownership threshold. Where 904(i) applies, the Service may, by regulation, resource the income of
the affected corporation(s) or modify the consolidated return regulations to prevent the avoidance of 904. The common
parent *23 may be foreign as well. The IRS has indicated that, in appropriate circumstances, it will invoke 269 and/
or 482 to eliminate or reduce the FTC benefit of transactions entered into to circumvent 904(i). See FSA 200233016
(Aug. 16, 2002).
Example. X, Y and Z are U.S. corporations that file a consolidated return. Z owns all of the stock of a foreign
corporation, F, which is a non-includible corporation, and F owns all the stock of W, a U.S. corporation, which is an
includible corporation. W cannot, however, be included on the consolidated return by virtue of F. In this situation, the
regulations provide that the foreign source income of W, X, Y and Z may be recharacterized as U.S. source income to
insure that the total tax liability of these companies is not less than their U.S. tax liability would be for FTC purposes
had W, X, Y and Z filed a consolidated return.
D. History of the Credit.
1. Introduction of the FTC. There was no credit for foreign taxes under the original income tax laws of 1909 and
1913. With tax rates still low in the United States and abroad, the absolute cost of total taxes paid by U.S. businesses
engaged in business overseas was tolerable. During World War I, tax rates increased sharply in the United States and
other industrialized countries. In addition, there was an enormous growth of foreign trade, and foreign taxes became more
onerous. As a result, in 1918 Congress introduced a credit against U.S. income taxes for income, war-profits and excess-
profits taxes paid ... to any foreign country, upon income derived from sources therein. See Revenue Act of 1918, ch. 18,
222(a), 238(a), 40 Stat. 1057; H.R. Rep. No. 767, 65th Cong., 2d Sess. 11 (1918).
2. Principal Amendments to the FTC Provisions Prior to the American Jobs Protection Act of 2004, P.L. Since 1918, there
have been many significant amendments to the foreign tax credit provisions. A notable series of amendments concerned
whether the foreign tax credit should be determined on a per-country basis (which prohibits cross-crediting of taxes
paid to several countries) or (versus) on an overall basis.
a. Limitations of FTCs (No Cross-crediting Allowed). In 1932, Congress limited otherwise allowable FTCs for taxes
paid to any one country based on a formula designed to prevent taxpayers from using foreign taxes paid to one country as
a credit against U.S. taxes imposed on income earned derived from another country, i.e., the per country limitation. The
overall limitation remained as an additional ceiling on the current use of otherwise available FTCs. In 1954, Congress
made the per-country limitation the only limit on the foreign tax credit. Then, in 1960 Congress reversed *24 itself and
allowed taxpayers to elect the overall limitation rather than the per country limitation.
b. Revenue Act of 1962. In the Revenue Act of 1962, Congress introduced a separate FTC limitation for nonbusiness
interest income to prevent funds generating investment interest from being transferred arbitrarily to any foreign country
in order to acquire any excess foreign tax credits generated by other income. It also required that the foreign tax credit
for non-business interest income be placed under a separate per-country limitation.
c. Tax Reform Act of 1976. The Tax Reform Act of 1976 introduced significant amendments to the FTC limitation
by eliminating the per-country foreign tax credit limitation and requiring taxpayers to recapture the tax benefit of so-
called overall foreign losses (OFLs) by resourcing subsequent foreign-source income to the United States. The Tax
Reform Act of 1986 also made more significant changes to the FTC limitation, by adding many separate limitation
baskets and introducing or modifying rules providing for (i) look-through treatment in some cases, (ii) separate limitation
loss recharacterization, (iii) limits on use of foreign losses, and (iv) issuing income and expense allocation rules designed
to properly set forth the numerator for purposes of computing net foreign course income.
d. Taxpayer Relief Act of 1997. Miscellaneous amendments were introduced by TRA 1997. Such reforms included
a minimum holding period for foreign stock as to which withholding taxes on dividends are sought to be credited;
modifications to the limitations periods; and changes in the treatment of subsequent adjustments in foreign taxes under
905.
e. Amendments Impacting the Foreign Tax Credit Rules Under the American Jobs Creation Act of 2004 (AJCA
2004).
(1) Reduction in FTC Limitation Baskets. Section 904(d)(1), as amended by AJCA 904, reduced the number of
FTC baskets from 9 to simply 2. As to the 2 baskets, the first basket is the passive income basket and the residual
or second basket is the general limitation basket. In general, passive income will continue to be income received or
accrued by any person, which is of a kind that would be foreign personal holding company income as defined in
954(c). As set forth in the Committee Reports to AJCA, other income is included in one of the two categories, as
appropriate. For example, shipping income generally falls into the general limitation category, whereas high *25
withholding tax interest generally could fall into the passive income or the general limitation category, depending
on the circumstances. Dividends from a DISC or former DISC from foreign trade income and certain distributions
from a FSC or former FSC are assigned to the passive income limitation category. The provision does not affect the
separate computation of foreign tax credit limitations under special provisions relating to, for example, treaty-based
sourcing rules or specified countries under 901(j). Financial services income of a financial services group or other
person engaged in the active conduct of a banking, insurance, financing or similar business, will generally be in the
general category. A financial services group is an affiliated group that is predominantly engaged in the active conduct
of a banking, insurance, financing or similar business. This change took effect generally for tax years beginning after
2006 and marked a substantial reform especially in light of Congress' prior concern with a taxpayer being able to
cross credit foreign taxes.
(2) Dividends From a 10/50 Corporation In general, a domestic corporation that owns at least 10% of the voting
shares of a foreign corporation that is not a CFC is considered to be a shareholder of a 10/50 corporation. Under
prior law, dividends from a 10/50 corporation were a separate income basket or category for FTC purposes. This
separate basket or silo rule under former 904(d)(4)(E) was eliminated in 1997. Dividends paid by a 10/50 company
that is not a PFIC from accumulated earnings and profits in taxable years beginning before January 1, 2003 are subject
to a single FTC limitation for all 10/50 companies (non-PFICs). These rules were revised in 2002 and then again in
AJCA. See Notice 2003-5, 2003-3 IRB 294.
Dividends paid by a 10/50 company out of earnings and profits accumulated in taxable years after December 31, 2002
are treated as income in a foreign tax credit limitation category in proportion to the ratio of the 10/50 company's earnings
and profits attributable to income in such foreign tax credit limitation category to its total earnings and profits (a
look-through approach). See 904(d)(4) added by P.L. 105-34, 1105. Post-2002 dividends paid by a noncontrolled
902 corporation will be deemed paid: (i) first, out of post-1986 undistributed earnings attributable to the period after
December 31, 2002, during which the corporation's earnings were entitled to look-through treatment under 904(d)
(4); (ii) thereafter, from all other *26 post-1986 earnings; and (iii) finally, out of pre-1987 earnings, on a LIFO basis.
Other special rules apply. See Notice 2003-5, 2003-1 C.B. 294.
In AJCA (2004), Congress repealed the separate basket limit for dividends from noncontrolled 902 corporations,
effective retroactively for taxable years starting after 2002, without regard to whether the noncontrolled 902
corporation is also a passive foreign investment company or whether the dividend is paid out of earnings and profits
accumulated in post-2002 or pre-2003 years. American Jobs Creation Act of 2004, 403(b)(1), 403(c). Under
the revised statutory provisions, the look-through rules in 904(d)(4), as amended by the 2004 legislation, apply to
dividends paid by a noncontrolled 902 corporation without regard to the year in which the earnings and profits out
of which the dividend is paid were accumulated. These revised rules also apply look-through treatment to dividends
that a controlled foreign corporation receives from a noncontrolled 902 corporation and then distributes to a U.S.
shareholder. AJCA repealed the rule in former 904(d)(2)(E)(ii), which disallowed any deemed paid credit under 902
for foreign taxes on high withholding tax interest (to the extent in excess of 5%) of a noncontrolled 902 corporation.
AJCA authorizes the Treasury and the Service to issue regulations regarding the carryback of tax allocable to a
dividend from a noncontrolled Section 902 corporation from a taxable year starting after 2002 to a taxable year starting
before 2003 for purposes of allocating the dividend among the separate basket categories in effect for the taxable year
to which the tax is carried.
Temporary and proposed regulations under 904(d)(4) and related provisions. In June 2006, the Treasury and the
Service issued a detailed set of temporary and proposed regulations under 904(d)(4) and related provisions. These
regulations contain provisions under 861 for apportioning interest expense of a noncontrolled 902 corporation
in order to apply the dividend look-through rule in 904(d)(4). These regulations also amend the 902 and 904
regulations to reflect the look-through treatment of dividends from noncontrolled 902 corporations under 904(d)(4).
*27 (3) Change in Overall Foreign and Domestic Loss Rules. An overall foreign loss (OFL), for purposes of
904(f), takes place when gross income for the tax year from foreign sources is exceeded by the sum of deductions
properly apportioned or allocated to foreign sources, without accounting for any NOL allowable for such year and
certain other items. See generally 904(f)(2). See also Treas. Reg. 1.1502-9. Where a U.S. taxpayer has an OFL usable
to offset U.S. source income, the U.S. effective tax rate on U.S. source income is reduced, sometimes substantially. If
there were no recapture rule with respect to the OFL, succeeding years' foreign source income can be used by the same
taxpayer availing himself of FTCs. Under 904(f), a portion of foreign source taxable income earned after an OFL
year (a/k/a excess foreign loss) is required to be recharacterized as U.S. source taxable income for FTC purposes.
This results in some foreign-source income being reclassified as U.S.-source income to make up for the foreign losses
that had been previously been converted and taken against U.S.-source income. If the foreign-source income exceeds
the amount of the foreign-source loss previously deducted against U.S.-source income, the excess will have to be
allocated in proportion to the foreign-source income baskets against which the foreign-source loss had been deducted.
Specifically, for purposes of the FTCs (901-908) and 936, the OFL recapture amount per 904(f)(l), in general,
is the lesser of: (i) the unrecaptured amount of excess foreign loss; or (ii) 50% (unless a taxpayer elects a higher
percentage) of the taxpayer's foreign source taxable income for such succeeding tax year. See 904(f)(l). There is no
rule, however, permitting overall domestic loss (ODL) recapture by permitting such amounts to be recharacterized
as foreign source taxable income in a subsequent tax year.
In AJCA, Congress enacted new 904(g)(l) which provides for income recharacterization (from a domestic loss
to a foreign loss) for any taxpayer who sustains an ODL for any tax year beginning after 2006 if certain conditions
are met for purposes of applying the FTC rules and 936. Under 904(g)(l), the amount of ODL recharacterized is the
lesser of: (i) the amount of the unrecharacterized ODL for years prior to such succeeding tax year; or (ii) 50% of the
taxpayer's U.S. source taxable income for such succeeding tax year. An ODL is any domestic loss to the extent such
loss offsets foreign source taxable income for *28 the tax year or for any preceding tax year by reason of a carryback.
A domestic loss is the amount by which the gross income for the tax year from U.S. sources is exceeded by
the sum of the deductions properly apportioned or allocated thereto (determined without regard to any carryback from
a subsequent tax year). 904(g)(2). Other special rules apply. See generally Treas. Regs. 1.904(g)-1, -2; Preamble,
T.D. 9371, 72 Fed. Reg. 72592 (12/21/07), removed by T.D. 9595, 77 Fed. Reg. 37576 (6/22/12).
Example. T generates a $100x U.S. source loss and earns $100x of foreign source income in year 1, and pays $30 of
foreign tax on the $100x of foreign source income. Since T has no net taxable income in year 1, no FTC can be claimed
in year 1 with respect to the $30 of foreign taxes. If the taxpayer then earns $100x of U.S. source income and $100x
of foreign source income in year 2, pre AJCA law did not allow the recharacterization of any portion of the $100x of
U.S. source income as foreign source income to reflect the fact that the previous year's $100 U.S. source loss reduced
the taxpayer's ability to claim the FTC. Under 904(g), T may recharacterize $50x of year 2 income as foreign source
income for purposes of applying the FTC limitation rules. The rule applies for tax years commencing after 2006.
(4) Foreign Tax Credits Paid by Partnerships Having Domestic Partners. Amendment to Indirect Foreign Tax Credit
Provision in Section 902. Prior to the AJCA, there was no statutory or regulatory provision on whether a domestic
corporation which was a partner in a partnership could claim indirect FTCs under 902 on dividends received by
the partnership. The often cited guidance in this area was Rev. Rul. 71-141, 1971-1 CB 21, which held that where
two domestic corporations, each of which owned a 50% interest in a domestic general partnership, each corporation
was entitled to claim 902 FTCs for dividends paid by a foreign corporation to the general partnership which held
40% of the foreign corporation's (presumably voting) shares. Note, that the 10% voting stock requirement is met by
multiplying the domestic corporation's ownership interest in the partnership times the partnership's percentage interest
in the foreign corporation. The IRS treated each partner as if it directly owned 20% of the foreign corporation's stock
and concluded that the domestic corporate partners were entitled to claim an indirect FTC under 902. To provide
certainty in this area, in AJCA, *29 Congress enacted 902(c)(7) which, as in Rev. Rul. 71-141, supra, applies
an aggregate theory approach in determining whether a domestic corporation-partner can meet the 10% ownership
requirement under 902. See Treas. Reg. 1.902-1(a)(1), as revised to reflect the policy rationale in 902(a)(7). See
Conf. Rept. No. 108-755, P.L. 108-357, @375.
(5) Direct Foreign Tax Credits per Section 901. Section 901(b)(5) formerly provided that an individual could claim
direct FTCs for his proportionate share of foreign taxes paid or accrued by a partnership. It was uncertain whether
a corporation was not to be considered an individual for this purpose. See also 702(a)(6)(end around rationale
for corporations to claim FTCs from partnerships under 901(b)(5)). The AJCA replaced individual in 901(b)
(5) with person, thus removing any implication that a corporation may not be entitled to claim direct FTCs with
respect to its proportionate share of foreign taxes paid or accrued by a partnership. Presumably this rule would apply
for purposes of 960 as well.
(6) Foreign Tax Credit Carryover Periods. AJCA extended the FTC carryforward period per 904(c) from 5 to 10
years and reduced the carryback period from 2 years to 1 year. The 10 year carryforward period applies to excess
FTCs carried to tax years ending after 10/22/04. The one-year carryback period applies to excess FTCs arising in tax
years beginning after 10/22/04.
(7) Repeal of Foreign Tax Credit Limitation on Alternative Minimum Tax. AJCA modified 59 by allowing full use
of the FTC against the alternative minimum tax. Previously, the limit was 90% of the AMT. The repeal is effective
for tax years beginning after 2004. The 100% use rule applies to both corporate and non-corporate taxpayers.
(8) Anti-FTC Shopping Provision. To prevent taxpayers from acquiring interests in foreign corporations primarily
to acquire FTCs, AJCA enacted new 901(1) which sets forth a minimum holding period for withholding taxes on
gain and income other than dividends for FTC purposes. More particularly, 901(1) blocks U.S. taxpayers from
purchasing FTCs by acquiring short-term ownership of property that generates certain types of income, e.g., interest,
rents or royalties, or gain subject to gross-basis foreign withholding taxes. Under 901(1)(1), FTCs may not *30 be
claimed with respect to foreign withholding taxes charged or assessed against any item of income or gain with respect
to property that the owner has held for 15 days or less during the 31 day period commencing 15 days before the right to
receive payment arises. An active business or dealer exception is provided in 901(1)(2). See also 901(k)(similar
anti-FTC shopping provision on dividends). Section 901(1) is a companion provision to 901(k) which applies only
to property that generates dividends. Section 901(l)'s effective date was for amounts paid or accrued more than 30
days after 10/22/2004.
(9) New Method for Allocating Interest Expense for FTC Purposes. Interest Expense Allocation Rules. Interest
allocation and apportionment affects both the proportion of foreign source income to worldwide income and the
amount of foreign source income allocated to each FTC basket; that proportion and that amount in turn affects the
FTC limitation. See e.g., Treas. Regs. 1.861-8(b)(l) (allocation); 1.861-8T(c)(l)(apportionment). More specifically,
interest expense that is allocated and apportioned to an FTC basket reduces the FTC limitation with respect to that
basket. In general, interest expense is attributable to all business activities and properties of a taxpayer regardless of any
specific purpose for incurring the obligation. See generally Treas. Reg. 1.861-9. See also Temp. Reg. 1.861-10T(b)
(non-recourse debt). This results in allocating and apportioning interest expense on the basis of assets and not on the
basis of gross income. See generally 864(e)(1), Temp. Reg. 1.861-9T.
The legislative history to AJCA observed that reform in this area was needed based on the awareness that at that
time the U.S. was the only country that subjected domestic corporations to harsh and anti-competitive interest expense
allocation rules. The then interest expense allocation rules resulted in U.S. companies allocating a portion of their
U.S. interest expense against foreign source income, even when the foreign corporation had its own debt. The tax
impact was that U.S. companies could be subject to double taxation which would dramatically rise borrowing costs
and making it more expensive for multi-nationals to invest in the U.S. Congress decided that by allowing a taxpayer
to adopt a worldwide fungibility approach, U.S. companies should not be required to allocate U.S. interest expense
against foreign source income unless their debt-to-equity ratio is higher in the U.S. than in foreign countries.
*31 Accordingly, in AJCA, for tax years beginning after 2008, Congress provided a one-time opportunity to elect a
worldwide fungibility approach to interest allocation and apportionment. Under the worldwide fungibility approach,
the third-party interest expense of the entire worldwide group will be treated as fungible. As a result, the taxable income
of the domestic members of the affiliated group from foreign sources generally will be determined by allocating and
apportioning third-party interest expense of the domestic members of a worldwide affiliated group on a worldwide
basis (i.e., as if all members of the worldwide group were a single corporation). See 864(e), (f). Determining whether
to make the election requires complex modeling of the worldwide group's projected income, foreign taxes, assets and
interest expense. Taxpayers deciding to make the election have a one-time window of opportunity-the common parent
of the U.S. affiliated group must make the election for its first tax year beginning after 2008 in which the parent's
worldwide affiliated group includes a foreign corporation. The 864(f) election applies to the tax year for which it is
made and all subsequent years, unless revoked with IRS consent.
f. Education Jobs and Medicaid Assistance Act of 2010 (P.L. 111-226). As part of a set of international tax law
revisions, 904(d)(6) was enacted which requires the creation of a separate basket for any item of income that would
be treated as U.S.-source under the sourcing rules contained in the Internal Revenue Code, but is re-sourced to another
country pursuant to the U.S. income tax treaty with that country. The provision equalizes the treatment of foreign branches
and disregarded entities with that of foreign subsidiaries, which were already subject to a similar rule under 904(h)(10).
Section 904(d)(6) is effective for taxable years beginning after August 10, 2010. Also enacted in this legislation was the
anti-splitter provision in 909 which is discussed in more detail in other portions of this Outline. Section 909 provides
that when a foreign tax credit splitting event occurs with respect to foreign taxes, the foreign taxes will not be taken into
account for US tax purposes until the related income is taken into account for US purposes by the US taxpayer or, in
the case of a 902 or 960 deemed paid credit, by either the 902 corporation (1) that paid or accrued the foreign tax
or (2) a US corporation with sufficient ownership to claim a 902 credit with respect to that corporation. A foreign tax
credit-splitting event occurs when related income is taken into account by a covered person, which essentially means
a person related to the taxpayer. This issue is discussed below at VII.
*32 g. American Taxpayer Relief Act of 2012 (P.L. 112-240). Section 102 of the TRA 2012, repealed 904(i), which
provision had restricted the allowable amount of FTCs to an individual's income tax liability reduced by the sum of
selected nonrefundable personal credits. The repeal resulted in the ensuing subsections being redesignated as 904(i),
(j), and (k). The Act also extended, through December 31, 2013, the exceptions to Subpart F for exempt insurance
income under 953(e) and income from the active conduct of a banking, financing, insurance, or securities business
under 954(h) and (i), along with the look-through rule of 954(c)(6). As with the repeal of 904(i), the extensions apply
to taxable years beginning after December 31, 2011.
E. Current Principles of the Credit.
1. Fundamental Objectives of the FTC. The principal objective of the foreign tax credit is to avoid double taxation on
foreign income earned by persons subject to U.S. federal income tax on that income. In addition, the system also seeks to
foster international trade and global investment by furthering capital export neutrality: the principle that U.S. taxpayers
investing abroad should not suffer higher tax burdens than U.S. persons investing domestically. The technical portions of
the FTC provisions deal with identifying the foreign income and the foreign income taxes paid by the taxpayer.
2. Foreign Income Tax on Foreign Source Income. If a taxpayer pays or properly accrues under its method of accounting
an income tax to a foreign government, 901 allows the taxpayer to reduce its tentative U.S. federal income tax on
the income by the amount of that tax. Although income from any source may bear a creditable foreign income tax,
the aggregate FTC cannot exceed the effective U.S. federal tax rate on the taxpayer's total foreign-source income. This
limitation (contained in 904) furthers the goal of avoiding double taxation without subsidizing the tax systems of other
countries.
3. Primacy of U.S. Tax and Legal Principles. Uncertainties can arise when U.S. tax definitions and principles of law
conflict with those of a foreign country. For example, definitions of income tax or corporation may differ from country
to country. Generally, U.S. courts will rely on U.S. law to identify the status of the taxpayer and the character of the tax,
and will treat the foreign law as a fact to be determined in the case. However, this general principle may be under attack
{see regulations under 894(c) and withdrawn Notice 98-11).
*33 II. CREDITABLE TAXES
A. Tax Requirement.
1. Imposed by a Foreign Country or U.S. Possession. See Burnet v. Chicago Portrait Company, 285 U.S. 1 (1931)(state
income tax imposed by New South Wales, a state of Australia, was a foreign country for FTC purposes). But see IRS Info.
2004-0176 (12/31/2004)(EU is not a foreign country for 901 purposes). In determining whether a tax paid to a foreign
government is creditable for U.S. income tax purposes, the first inquiry is whether the foreign tax is imposed on income,
war profits or excess profits. Additions to tax in the form of penalties and interest are not taxes and not creditable. Section
903 allows a FTC for taxes paid or accrued to a foreign government in lieu of a generally imposed income tax. Other
limitations are relevant. See 904 and 907.
2. Definition of Foreign Country or U.S. Possession. In Treas. Reg. 1.901-2(g)(2) it is explained that the term foreign
country means any foreign state, any possession of the United States, and any political subdivision of any foreign state or
of any possession of the United States. The term possession of the United States includes Puerto Rico, the Virgin Islands,
Guam, the Northern Mariana Islands and American Samoa.
3. Indirect Payment to Foreign Government Sufficient. The payment of a foreign income tax need not be made directly
to the foreign government. See, e.g., Rev. Rul. 74-58, 1974-1 C.B. 180 (payment to Brazilian public benefit corporation
to fight illiteracy deemed payment to foreign government).
4. Tax on Business Revenues Distinguished From Taxes on Income or In Lieu of Income Tax.
a. In General. A threshold consideration in evaluating whether a particular tax paid to a foreign government (or
U.S. possession) qualifies for a FTC under 901 or a deemed foreign tax under the in-lieu-of standard set forth under
903, requires determining whether the relationship between the taxpayer and the foreign government is one in which
taxes are paid at all. A liability pursuant to a levy imposed by foreign law is creditable if the foreign levy satisfies
the requirements of either 901 or 903. Whether a levy is an income tax under 901 or an in-lieu-of tax under 903
is determined independently for each separate foreign levy. As to a foreign levy Treas. Reg. 1.901-2(a)(1) provides,
in general, that a foreign levy is an income tax if and only if: (i) it is a tax; and (ii) the predominant character of that
tax is that of income tax in the U.S. sense.
*34 To determine whether a levy satisfies 901 or 903, it is first necessary to determine what is the levy in
question. When a U.S. taxpayer engages in business transactions with a foreign government, the government can deal as
a sovereign, a commercial counterparty, or as both. For example, this can arise in the development of mineral resources
owned by a foreign sovereign. Thus, U.S. taxpayers must engage in business relations with the same entities to which
they pay taxes. The taxes paid may be hard to distinguish in the context of the overall contractual relationship and may
be offset by the benefits or other economic incentives realized by the taxpayer from the foreign government. Thus, the
payments by the U.S. taxpayer to the government can be of an uncertain (or dual capacity) character- perhaps royalties,
rents, windfall profits taxes or direct taxes on foreign source income. The Service has issued various rulings in this
area. For example, the Service views fees imposed are considered taxes on income if their primary purpose was to raise
revenue as compared with having a primary purpose to restrain an occupation, privilege or dangerous activity, i.e., the
primary purpose was to regulate. See, e.g., Rev. Rul. 60-366, 1960-2 C.B. 63. Still, a foreign levy intended primarily as
a revenue is still a tax despite having some (but not primary) regulatory effect. This would include a tax on the value
of bank stock or a gross receipts tax to qualify to do business. On the other hand, levies that were intended primarily as
revenue measures were considered to be taxes even though the taxes had some incidental regulatory function. See, e.g.,
Rev. Rul. 54-598, 1954-2 C.B. 121, obsoleted by Rev. Rul. 2003-67, 2003-26 I.R.B. 1119. On the other hand, special
assessments for improvements taxpayer were held not to be taxes if the amount paid was determined according to the
specific improvements made for each particular property owner. Mahler v. Commissioner, 119 F.2d 869 (2d Cir. 1941),
cert. denied, 314 U.S. 660 (1941).
b. Receipt of Economic Benefit. Under Treas. Reg. 1.901-2(a)(2), a foreign levy is a tax if compulsory under authority
of the law of a foreign country. A penalty, fine, interest, or similar obligation is not a tax, nor is a customs duty a tax.
Moreover a foreign levy is not a tax to the extent the taxpayer receives a specific economic benefit in exchange for
payment of the levy. The right to extract petroleum or other minerals that are owned by the foreign jurisdiction imposing
the levy is a specific economic benefit. Thus, a taxpayer engaged in the extraction of government-owned minerals is
considered to receive a specific economic benefit and is denominated in the regulations as a dual capacity taxpayer --
i.e., a person who is both a taxpayer and the recipient of a specific economic benefit. The dual capacity taxpayer has the
burden of establishing the portion of the levy which is a tax. The remainder is *35 considered to be paid in exchange
for the right to extract minerals (generally a royalty). Where a foreign levy on a dual capacity taxpayer does not differ
as to rate or tax base computation, it is generally creditable under 901 or 903. See Treas. Regs. 1.901-2A(a)(l).
c. In Lieu of Taxes: Section 903. Section 903 allows a credit (under 901), for a tax paid in lieu of a tax on income
... otherwise generally imposed by any foreign country or by any possession of the United States. See Treas. Reg.
1.903-1(a). Commentators have identified seven contexts or factors involved in making a particular determination on
a tax in lieu of income tax under 903 including: (i) whether the particular levy in issue is imposed is a tax; (ii)
whether the taxing authority is considered a foreign country or U.S. possession; (iii) if the levy is a tax, whether it is a
separate tax to which the creditability criteria of 901 or 903 will be applied or, alternatively, part of a unified tax whose
creditability must be determined as a whole for the entire tax; (iv) whether the tax is an income tax under 901; (v) if
not an income tax, whether the assessment involved is an in-lieu-of tax under 903; (vi) whether the person claiming
the credit is the taxpayer with respect to the foreign tax; and (vii) the amount of the creditable foreign tax that is paid
or accrued. See Christina Letourneau v. Comm'r, T.C. Memo. 2012-45.
5. U.K. Windfall Profits Tax Held Creditable by United States Supreme Court. In PPL Corporation & Subsidiaries, 111
AFTR 2d 2013-723 (5/20/2013), the Supreme Court, in an unanimous decision, per Justice Thomas, resolved a split of
authority between the Fifth and Third Circuits, and held that the United Kingdom's one-time windfall tax paid by the
taxpayer through a U.K. based partnership, were creditable foreign taxes under 901(a). The Supreme Court agreed with
the Tax Court below and the taxpayer that the windfall tax in issue had the predominant characteristic of an excess profits
tax within the meaning of Treas. Reg. 1.901-2(a) and therefore was creditable under 901. Thus, the Court reversed
the decision of the Third Circuit Court of Appeals which held to the contrary. The windfall tax in issue was imposed
under the new Labour Party adopted rule when it took over control of the Parliament in 1997. Previously, the Labour
Party objected to the concept of privatization embraced by the Conservative wing. The new tax was imposed on 32 U.K.
companies that were authorized to privatize between 1984 and 1996 by the Conservative government. PP&L Resources,
Inc. (PP&L) was a global energy company. Through various subsidiary corporations, it produced electricity, sold wholesale
and retail electricity, and delivered electricity to customers. It provided such services in the United States in the Mid-
Atlantic and Northeast regions and also in the United Kingdom. During 1997, South Western Electricity plc (SWEB) a
*36 U.K. private limited liability company, was PP&L's indirect subsidiary. Its principle activities at the time included
distribution of electricity to 1.5 million customers in England. In 1990, the U.K. privatized 12 regional electric companies
including SWEB. The ordinary shares or common stock of these companies were sold to the public as part of a flotation.
Some of the companies were required to continue providing services for a fixed period at the same rates offered under
government (pre-privatized) control. Many of these companies became far more efficient and earned substantial profits
in the process of the privatization.
The one-time windfall profits tax was 23% of the difference between each company's profit-making value and its
flotation value, the price for which the U.K. government sold the stock which many British subjects felt was priced
below value.
The relevant statute defined each company's profit-making value as its average annual profit times its price-to-earnings
ratio. Average annual profit was defined as the average daily profit over a stated initial period which for SWEB was
the first four years after privatization times 364. Instead of using the companies' actual price-to-earnings ratios, the statute
imputed a ratio of 9 for all companies, as the government thought that such ration approximates to the lowest average
sector price-to-earnings ratio of the companies liable to the tax. SWEB filed the windfall tax return with the Department
of Inland Revenue in November 1997 and paid its windfall tax obligation.
Under section 901(b), a credit for foreign taxes accrued or paid by a taxpayer is allowed only for those taxes imposed
by a foreign country or U.S. possession which are income, war-profits, or excess profits taxes; or taxes imposed in lieu
of income taxes upon gross income, gross sales, or units of production. For a foreign tax to be creditable, its predominant
character must be that of an income tax in the U.S. sense. The predominant character of a foreign tax is that of an income
tax in the U.S. sense if the foreign tax is likely to reach net gain in the normal circumstances in which it applies and isn't
a soak-up tax (i.e., a tax liability which depends on the availability of a credit for the tax against an income tax liability to
another country). Treas. Regs. 1.901-2(a)(1)(h), Reg. 1.901-2(a)(3).
The petitioner in the tax case, PPL Corporation, was a part owner of the privatized SWEB, and claimed, against its U.S.
income tax liability, its pro rata share of the credit for the windfall tax the plc paid in 1997. In doing so it relied upon
901 (b)(1) which provides that any income, war profits and excess profits taxes paid overseas are creditable against
U.S. income taxes. Treas. Reg. 1.901-2(a)(1) provides that a foreign tax is creditable if its predominant character is that
of an income tax in the U.S. sense. This regulation codified a longstanding principle that can be sourced to *37 Biddle
v. Commissioner, 302 U.S. 573, 578-579 (1938). See also United States v. Goodyear Tire & Rubber Co.. 493 U.S. 132,
145 (1989 (application to 902)).
The Internal Revenue Service, in auditing PPL's 1997 corporate income tax return, denied the foreign tax credits for the
windfall tax paid by the U.K. plc for 1997. SWEB's windfall tax was approximately 90.5 million pounds. In response
to proposing a deficiency in federal income tax for the believed to be non-creditable foreign tax, the taxpayer filed a
petition with the Tax Court. The Tax Court found for PPL since the windfall tax was an amount, under U.S. tax principles,
which could be viewed as a tax on excess profits in accordance with the regulations, i.e., its predominant character is
that of an income tax in the U.S. sense. The tax was on the net gain derived by the U.K. plc of which a pro rata portion
directly passed through to its U.S. partner. See 135 T.C. 304 (2010).
The government appealed the Tax Court's decision before the Third Circuit Court of Appeals. The Tax Court's decision
was reversed. 665 F.2d 60, 68 (2011). The appellate court opined that the terms income, war profits, and excess profits
referred to in Treas. Reg. 1.901-2 should be thought of in the singular sense of whether it is an income tax. Accordingly,
the Third Circuit stated that a foreign assessment is an income tax if it has the predominant character of an income
tax in the U.S. tax sense. It therefore must satisfy the U.S. income tax concepts of: (i) a realization event requirement;
(ii) the gross receipts requirement; and (iii) the net income requirement. See Treas. Reg. 1.901-2(b). The Service argued
that the windfall tax did not meet either the gross receipts or net income requirement. The Third Circuit felt that that the
tax base used in the windfall tax could not be the initial period profit alone unless the Court rewrote the tax rate. In its
view, the windfall tax is in substance a tax on the difference between the company's flotation value and its imputed
profit-making value the later term being based on a formula. It is the price that the Labour government believed that each
company should have been sold for given the actual profits earning during the initial period. The Third Circuit's decision
was in conflict with the Fifth Circuit Court of Appeals taxpayer-favorable decision in Entergy Corporation & Affiliated
Subsidiaries v. Comm'r. 683 F.3d 233, 239 (5th Cir. 2012).
The Supreme Court held that the predominant character of the windfall tax is that of an excess profits tax and is
creditable under 901. In reviewing the subject regulation, Treas. Reg. 1.901-2(a)(1), there are several principles that
must be addressed. First, the predominant character of a tax or the normal manner in which a tax applies is controlling.
A foreign tax on income, war profits, or excess profits, in most instances will be creditable even where it affects a handful
of taxpayers differently. Second, a foreign government's characterization of the tax is not determinative for purposes of
Treas. Reg. 1.901-2(a), *38 instead it is its economic effect. Stated more directly, foreign tax creditability depends on
whether the tax, if enacted in the United States, would be an income, war profits, or excess profits tax. Third, the regulation
provides that the predominant character of the tax is like a U.S. income tax [i]f ...the foreign tax is likely to reach net
gain in the normal circumstances in which it applies. There are three tests under the regulations for determining whether
a foreign tax is imposed on net gain. Again, as mentioned, those three parts are realization, gross receipts and net income.
See Treas. Regs. 1.901-2(b)(2), 2(b)(3) and 2(b)(4). The Supreme Court viewed the windfall tax as imposed on realized
net income which was disguised as a tax on the difference between flotation value and initial period value. In analyzing
the algebraic formulation of the tax, the Court noted that the economic effect of the formula was to convert floatation value
into the profits a company should have earned given the assumed price-earnings ratio.
The Supreme Court stated that the rearranged tax formula demonstrates that the windfall tax is economically equivalent
to the difference between the profits each company actually earned and the amount the Labour government believed it
should have earned given its floatation value. For the 27 companies that had 1,461-day initial periods, the U.K. tax formula
effectively imposed a 51.71% tax on all profits earned above a threshold; a classic excess profits tax. It is not, as argued,
an imputed gross receipts tax and not creditable.
Based on the logic set forth in the Tax Court's opinion below and as further magnified in the opinion of Justice Thomas, it
may be contended that reason and logic prevailed. It did. Clearly the regulation in issue should not have been compressed
into solely a tax on income as the Third Circuit felt. The fact the Court was unanimous in its view, although Justice
Sotomayer, in her concurring opinion, wanted to note that if the record were different the tax may not have been analogous
to an excess profits tax, is indeed important and may even be surprising to some. For PPL as well as many tax practitioners,
the result made perfect sense. Material on PPL taken from August, Fox Tax Law Developments, Blog Post, May 21, 2013.
6. Disqualifying Effect of Subsidies. When a foreign government favors particular taxpayers, the question arises whether
the levy in question that is imposed on such taxpayers is creditable under 901, 902 or 960. There are many kinds of
subsidies that governments can grant to businesses. The definition of subsidy encompasses any rebate, refund, credit,
deduction, payment, discharge of an obligation or any other benefit conferred by the foreign government to the taxpayer
itself or to a related person, to any party to the transaction, or to any party to a related transaction. When the benefit granted
is closely tied to taxes paid, the substance of the transaction will govern over its form in determining *39 whether the
taxes were borne by the taxpayer at all. When subsidies that are related to tax payments are paid by foreign governments
directly or indirectly to the taxpayer, a question arises as to the actual amount of tax that is considered paid. The Tax
Reform Act of 1986 enacted 901(i). Section 901(i) provides that payments made to a foreign country are not creditable
taxes to the extent that they result in a subsidy from that country to the taxpayer, a related person (per 482) or to a party to
the relevant transaction or a related transaction. Treas. Regs. 1.901-2(a)(i), - 2(e)(3). See, e.g., Rev. Rul. 78-258. 1978-1
C.B. 239, mod'f'd Rev. Rul. 89-119 (Brazil 25% withholding tax on interest paid by Brazilian borrowers to foreign lenders
limited to amount withheld in excess of subsidy granted borrowers); Rev. Rul. 84-143, 1984-2 C.B. 127 (availability to
Mexican borrowers of a preferential exchange rate for obtaining U.S. dollars to make payments of principal and interest
on loans made by certain U.S. lenders did not constitute a subsidy to local borrowers which would reduce the U.S. lender's
credit for the withholding tax).
7. Payment of Subsidy To Another Person. An indirect subsidy also results if the government provides a subsidy to
another person who is related to (commonly controlled with) the taxpayer if, once again, the subsidy relates to the tax
imposed on the taxpayer (or the tax base). Treas. Reg. 1.901-2(e)(3)(ii)(B).
Example. Country A imposes a 30% tax on nonresident lenders with respect to interest they receive from borrowers who
are residents of Country A. This is established to be a tax in lieu of income tax. Country A remits to resident borrowers
who take out foreign loans an incentive payment equal to 20% of the interest paid to nonresident lenders.
The incentive payment is considered a subsidy because (1) it is determined by reference to the base used to compute the
tax on the nonresident lender (the interest paid) and (2) it is provided to a party to the transaction (the borrower). Therefore,
two-thirds (20% 30%) of the amount withheld by the resident borrower from interest payments to the nonresident lender
is not a creditable tax
*40 8. Soak-Up Taxes. No foreign tax credit is allowable for foreign taxes imposed only in instances in which the
taxpayer's home country allows a credit for such foreign taxes. This is a clear example of a provision designed to mitigate
the risk that the United States will subsidize a foreign government through the FTC mechanism. In particular, no foreign
tax credit is allowable for foreign taxes imposed only in instances in which the taxpayer's home country allows a credit for
such foreign taxes. This is a clear example of a provision designed to mitigate the risk that the United States will subsidize
a foreign government through the FTC mechanism. Treas. Reg. 1.901-2(c).
Example: Assume that a country has a withholding rate on dividends received by non-residents of 15% while the rate
imposed on residents of countries that permit FTCs is 20%. Under the soak-up tax rule, the difference between the 20%
(creditable) tax and the 15% tax is not creditable.
In determining whether the higher rate is related to the availability of a credit in another country, it seems sufficient that
all taxpayers subject to the higher tax are residents of credit countries. It does not seem necessary that the higher tax apply to
all taxpayers resident in credit countries. In Rev. Rul. 2003-8, the Service addressed whether a particular Costa Rican tax is
a soak-up tax. Under the facts, Costa Rican law imposes a withholding tax on various items of income paid to nonresidents.
However, the government can grant a partial or total exemption from such tax if the withholding agent can prove that the
income recipient will not receive a credit for the withholding tax in its home country. The ruling holds that the withholding
taxes are non-creditable soak-up taxes. Rev. Rul. 2003-8 was issued presumably to provide U.S. taxpayers with official
U.S. certification that the tax would not be creditable, and thus enable them to obtain an exemption from the Costa Rican
tax. Treas. Reg. 1.901-2(c). See Rev. Rul. 87-39, 1987-1 C.B. 180, in which the IRS held that a Uruguayan withholding
tax imposed on dividends and profits paid to foreign shareholders was not creditable because it was only imposed if the
recipient's country of domicile allowed a credit for such tax. See also IRS Info. Letter 2010-0205 (similar analysis as to El
Salvador withholding tax on interest payments to foreign financial institutions). Treas. Reg. 1.901-2(c)(2), Ex. 1.
9. Service's Attack on So-Called Foreign Tax Credit Generators. Due to dissimilarities in domestic and foreign tax
law, what many sophisticated cross-border borrowers and lenders agreed to do, primarily for the receipt of tax benefits and
therefore effective tax rate reduction, was enter into various forms of essentially similar transactions, at least similar from
the output of FTCs to the U.S. borrower, that the Internal Revenue Service referred to as foreign tax credit generators.
The transactions referred to as FTC generators generally involve a U.S. parent corporation which *41 forms or already
has in place a wholly owned subsidiary in a foreign country in which the foreign bank or foreign financial institution is
based. Instead of a direct borrowing on terms, including interest, the lender takes an equity position directly in the foreign
based subsidiary. Compare Compaq Computer, 277 F.3d 778, 784-786 and IES Industries, Inc., 253 F.3d 350 (8th Cir.
2001) with Bank of New York Mellon Corp. v. Comm'r, 140 T.C. 2 (2013) and American International Group. Inc. v.
United States, 111 AFTR 2d 2013-1472 (DC NY, 2013). Alternatively it could take the form where the foreign based
lender instead of receiving a debt instrument, receives a preferred interest with fixed cash flow provision in a joint venture
position in a foreign partnership. See, e.g, Pritired 1. LLC, 108 AFTR 2d 2011-6605 (DC Iowa, 2011), discussed infra.
10. SPIA Proposed and Temporary Regulations: Service's Response to FTC Generators. In March 2007 the IRS
issued proposed regulations (REG-156779-06) revising Treas. Reg. 1.901-2(e)(5). The revision was designed so that
foreign entities in a U.S.-owned foreign group would be treated as a single taxpayer and that payments to a foreign
tax authority would be treated as noncompulsory payments (and therefore not eligible for FTCs) if attributable to a
structured passive investment arrangement or SPIA (structured passive investment arrangements) as defined. After
a hearing on the proposed regulations was held, in Notice 2007-95, the Service severed the portion of the proposed
regulations pertaining to U.S. owned foreign groups. On July 16, 2008, the Service issued final, temporary and proposed
regulations T.D. 9416; 2008-46 IRB 1142; 73 F.R. 40727-40738 on SPIAs addressing structured passive investment
arrangements, incorporating several changes recommended by the public and requesting additional comments. Structured
passive investment arrangements are designed to create a foreign tax liability for the sole purpose of generating foreign
tax credits. The parties to the transactions exploit differences between U.S. and foreign law to allow the U.S. taxpayer to
claim a credit for the purported foreign tax payments while allowing the foreign party to claim a foreign tax benefit. The
new temporary regulations retain the general rule that all foreign entities for which a U.S. person has a direct or indirect
interest of 80% or more is treated as a single taxpayer. By treating foreign payments attributable to highly structured passive
investment arrangements as noncompulsory payments, foreign tax credits for these nontax amounts are disallowed.
Under the temporary regulations, a SPIA is, in general, an arrangement that meets six conditions. The arrangement must
contain:
a. A special purpose vehicle of which (1) substantially all the gross income is passive, (2) substantially all the assets
are held to produce passive income, and (3) a foreign tax payment is made that is attributable to the entity's income.
*42 Treas. Reg. 1.901-2T(e)(5)(iv)(B)(l). The determination of passive income is the FPHC definition in 954(c),
with modifications.
b. The arrangement must contain a U.S. party that is eligible to claim foreign tax credits. Treas. Reg. 1.901 -2T(e)
(5)(iv)(B)(2).
c. The foreign tax payment as structured is expected to be substantially greater than would be expected if the U.S.
party held the relevant assets directly, i.e., the FTC generator effect. Treas. Reg. 1.901-2T(e)(5)(iv)(B)(3).
d. The arrangement results in a foreign tax benefit to a foreign counterparty to the arrangement (or is related to such
a counterparty) but is not related to the U.S. party. Treas. Reg. 1.901-2T(e)(5)(iv)(B)(4).
e. The arrangement must include a foreign counterparty that either (1) owns at least 10% of the special purpose vehicle,
or (2) acquires at least 20% of the special purpose vehicle's assets. Treas. Reg.1.901-2T(e)(5)(iv)(B)(5).
f. The arrangement is subject to inconsistent tax treatment by the United States and a foreign country that either (1)
receives the foreign tax payment or (2) confers a tax benefit on a party to the arrangement. Treas. Reg. 1.901-2T(e)
(5)(iv)(B)(6).
If these conditions are satisfied, the foreign tax payments associated with the SPIA are presumptively noncreditable,
even if there is a valid business purpose for the arrangement, on the theory that the taxpayer has structured the transaction
in order to pay foreign taxes that it would not otherwise be required to pay, therefore violating at least the spirit of the
compulsoriness requirement
Also adopted without change is the so-called inconsistent treatment condition. The temporary regulations were effective
on July 16, 2008.
11. SPIA Final Regulations. On July 18, 2001, the Service issued final regulations (T.D. 9535) under Treas. Reg.
1.901-2(e) pertaining to blocking use of passive income foreign tax generators. The final regulations generally adopted,
with some changes the proposed regulations published in 2008 (REG-156779-06). The temporary regulations (T.D. 9416)
were withdrawn. Overall, the final regulations retain the structure and basic rules contained in the temporary regulations
providing that amounts paid to a foreign taxing authority that are attributable to a structured passive investment arrangement
(SPIA) are not treated as an amount of tax paid for purposes of the FTC. For further discussion of the final regulations to
passive income generators under - 2(e) see discussion below.
*43 See Andersen, Foreign Tax Credits, 1.03, Warren, Gorham & LaMont (2013).
B. Tax on Income Requirement.
In order to be creditable, and as mentioned above, a foreign governmental levy must be a tax whose predominant character
is that of an income tax in the U.S. sense. The main considerations in determining whether a payment is an income tax are:
(1) whether the tax was triggered by an event of realization; (2) whether the tax base is imposed on gross receipts; and (3)
whether the foreign tax is imposed on net income. See Treas. Reg. 1.901-2.
1. Realization. The realization requirement provides that a tax is not an income tax unless it is imposed on income (as
opposed to capital, property or some other measure) and is not imposed prematurely (i.e., before the income in question has
been economically realized by the taxpayer). The term generally includes all realization events under U.S. tax principles,
as well as some events that occur before and after realization events as defined under U.S. principles, such as: (1) recovery
or recapture of previously allowed tax deductions or credit, (2) change in property value, and (3) the physical transfer,
processing, or export of readily marketable property.
2. Gross Receipts. The starting point for the foreign tax base must generally be actual gross receipts. If the foreign tax
base is not based on actual gross receipts, it will still constitute an income tax if it is imposed on gross receipts calculated
by a method that does not overstate them.
3. Net Income. Ultimately, to be creditable a foreign tax must be imposed on net income. This requirement is satisfied
if the predominant character of the tax allows for (1) the recovery of costs and expenses attributable to gross receipts, or
(2) the recovery of costs and expenses that approximate actual costs and expenses.
4. PPL Corp. See discussion of Supreme Court's recent decision on PPL Corp., supra.
III. THE DIRECT CREDIT
A. In General.
Section 901 allows a taxpayer to take a direct credit against its U.S. federal income tax liability for income taxes it is
required to, and actually does, pay or accrue to a foreign government. Section 904 places limitations on the amount of credit
allowed, but within the scope of those limitations the taxpayer may reduce his federal income tax dollar for dollar.
*44 B. Paid or Accrued Requirement.
The amount of tax that can be taken as credit is only the amount properly paid or accrued. For example, if a country offers
the equivalent of an investment tax credit, the foreign tax credit is equal to the foreign income tax otherwise due reduced by
the local tax credit. Amounts reasonably certain to be refunded or forgiven by the foreign government are not taxes paid.
The same is true for the amount offset by subsidies tied to the amount of the tax, whether or not given directly to the taxpayer.
C. Technical Taxpayer Requirement.
1. Section 901(b): Persons Eligible for Foreign Tax Credits. Linked to the question of whether a foreign income tax has
been properly paid or accrued is the issue of whether the person seeking an FTC is in fact the party that bore the foreign tax
in the first place. Section 901(b) provides that U.S. citizens, individual residents, and domestic corporations are entitled to
a foreign tax credit. See, however, 901(c) which provides that a resident alien will not be permitted a credit if the foreign
country of which he is a citizen does not give U.S. citizens resident in such country a reciprocal credit and the President
of the United States determines that it is in the public interest to deny such a credit. In addition, certain nonresident aliens
and foreign corporations that are engaged in a trade or business in the United States are entitled to a credit to the extent
provided in 906 for creditable foreign taxes that are imposed on income that is effectively connected with the conduct
of a U.S. trade or business.
a. Taxpayer Must be Liable for the Foreign Tax. The taxpayer for these purposes is the person on whom foreign law
imposes legal liability for the tax-the technical taxpayer even if another person (e.g., a withholding agent) remits the
tax. See Treas. Reg. 1.901-2(f)(1). If foreign income tax is imposed on the combined income of two or more related
persons (e.g., a husband and wife, or a corporation and one or more of its subsidiaries) and they are jointly and severally
liable for the income tax under foreign law, each person is considered to pay his, her or its share of the tax. Treas.
Reg.1.901-2(f)(3).
b. Application to Corporations. A U.S. corporation can be the taxpayer for this purpose if it is legally liable to
pay the foreign tax. It also is deemed to pay foreign taxes if it receives a dividend from a foreign corporation that
has paid them. 902, 78. More particularly, and as explained elsewhere in this outline, a domestic corporation that
receives a dividend from a foreign corporation in which it owns at least 10% of the voting stock is deemed to have paid
a proportionate amount of the taxes paid by the foreign corporation based on the ratio of the amount of such dividend
*45 (without regard to 78) to the foreign corporation's post-1986 undistributed E&P. Under 902(b), the taxes paid
by lower-tier foreign corporations down to the sixth tier can flow through to the U.S. parent as long as the immediate
foreign parent owns at least 10% and the U.S. parent indirectly owns at least 5% of the lower-tier foreign corporation.
In addition, a domestic corporation that is a U.S. shareholder of a controlled foreign corporation also is deemed to pay
foreign taxes on its share of the CFC's subpart F income. 960.
2. Indirect Payment of Foreign Taxes. Section 901(b)(5) allows a credit to any individual (or person) who would
otherwise be entitled to a FTC and who is a partner in a partnership or a beneficiary of an estate or trust for the individual's
proportionate share of foreign taxes paid or accrued by the partnership or estate or trust during the taxable year. Small
Business Job Protection Act of 1996, P.L. 1996, P.L. 104-188 (amended 901(b)(5) to provide, under regulations to be
issued, taxes imposed on a foreign trust that is a grantor trust but for application of 672(f), include taxes imposed by a
foreign jurisdiction on the grantor (or such other person) required to pay income tax with respect to taxes paid by the trust
on foreign source income.
3. Proportionate Share of Foreign Taxes of a Partner in a Partnership. While the 901 regulations do not address what is
a U.S. person's proportionate share of foreign taxes, the substantial economic effect test of 704(b)(2) limits the ability to
specifically allocate taxes disproportionately to partnership net income. In 2004, the IRS issued temporary and proposed
regulations under 704(b) to provide specific rules for allocating creditable foreign taxes to partners in a partnership. The
regulations provide that allocations of creditable foreign taxes cannot have substantial economic effect and, therefore, must
be allocable in accordance with the partners' interests in the partnership. The regulations establish a safe harbor that is met if
the partnership agreement both: (1) satisfies the economic effect test of Treas. Reg. 1.704-l(b)(2)(ii) (b) or (d) throughout
its term; and (2) provides for allocations of foreign taxes in proportion to the partners' distributive shares of the income to
which the taxes relate. This safe-harbor regulation also requires strict adherence to the capital account maintenance rules.
4. Matching Foreign Source Income and Foreign Taxes. Treas. Reg. 1.904-provides that a tax is related to income if
the income is included in the foreign tax base upon which the foreign tax is imposed.
5. Non-residents' Ability to Claim Foreign Tax Credits: Section 906. Under 906, nonresident alien individuals and
foreign corporations doing business in the United States are allowed a foreign tax credit or a deduction for foreign taxes
paid with respect to income effectively *46 connected with the conduct of a U.S. trade or business (ECI). Certain
limitations apply to the 906 allowance of a credit or a deduction. Section 906(b)(1) provides that foreign taxes imposed
by the foreign country or possession solely on the basis that the nonresident is a citizen or resident or is incorporated in
such country are not taken into account for this purpose. See, e.g., Rev. Rul. 80-243, 1980-2 C.B. 413 (denial of deduction
under 906 for U.K. tax on U.S.-source ECI that is imposed because the corporation was a U.K. resident is not contrary to
the U.S.-U.K. Income Tax Treaty). The 906 credit is only allowable against ECI and is not available to reduce the branch
profits tax imposed on a foreign corporation in accordance with 884. 906(b)(5). Further, taxes taken into account under
906 cannot again be taken into account by a U.S. shareholder of the foreign corporation for purposes of the deemed paid
credit under 902. 906(b)(7).
a. Tax Must be Imposed on the Recipient. A withholding agent may be required to remit a tax on account of a
payment it made to another, but for the recipient to claim the FTC it must be demonstrated that the tax withheld was
imposed on the recipient, even though actually collected by the payor. This technical taxpayer requirement can pose
significant issues when the United States and the foreign country define certain key concepts differently, such as whether
the foreign payor of an item of income received by a U.S. recipient is in fact a separate entity. See Arundel Corporation
v. United States. 102 F. Supp. 1019 (Cl. Ct. 1952); Abbott Laboratories Int'l Co. v. United States, 160 F. Supp. 321 (N.D.
Ill. 1958), aff'd per curiam, 267 F.2d 940 (7th Cir. 1959) (acq.). The concept has also been reborn as a treaty issue, with
the issuance of regulations under I.R.C. 894(c) designed to avoid the whipsaw effect of using a taxable foreign
entity that has elected transparent treatment for U.S. tax purposes under the check-the-box rules (or vice-versa).
b. Application to Foreign Disregarded Entity. In Guardian Industries Corp. v. United States, 65 Fed. Cl. 50 (Ct. Fed.
Cl. 2005), aff'd, 477 F.3d 1368 (Fed. Cir. 2007), the IRS failed in its effort to deny the FTC to a US multinational on
account of taxes paid by its controlled affiliates of a Luxembourg subsidiary that had elected to be treated as a disregarded
entity under the check-the-box rules. See, e.g., Dover Corp. v. Comm'r, 122 T.C. 524 (2004). The taxpayer in Guardian
Industries was the parent corporation of a group of Luxembourg companies forming a fiscal unity for Luxembourg tax
purposes. Under the fiscal unity rules, the parent is legally responsible for paying the taxes of the group, and the loss
incurred by one member of the group may be used to offset the income of others.
*47 In Guardian, supra, the taxpayer formed a Luxembourg parent of a Luxembourg fiscal unity. Guardian checked
the box under the regulations to 7701 with respect to the top Luxembourg parent so that it was a disregarded entity (DE)
for U.S. tax purposes. This then led to the rationale that the U.S. parent corporation, Guardian, would be passed through
the fiscal unity group's FTCs. More particularly, the other members of the Luxembourg fiscal unity were regarded
as CFCs for U.S. tax purposes. The effect was a classic splitter arrangement-foreign income earned by the CFCs was
deferred for U.S. tax purposes, while the Luxembourg taxes paid by the Luxembourg parent flowed through to the U.S.
tax return of Guardian and were usable as credits to shelter other income.
(1) Court of Federal Claims Decision. The issue before the Court was whether the top Luxembourg parent was
jointly and severally liable for the tax with other members of the group. The court relied on testimony of experts on
Luxembourg law to hold that the top Luxembourg parent was solely liable for the tax and therefore was, by virtue of the
defective entity rules, payable by Guardian Industries. United States Court of Federal Claims granting the motion for
summary judgment of appellee Guardian Industries Corp. and Subsidiaries and order refund in tax for $2,729,268.00
for overpayment of taxes for the tax period ending December 31, 2001.
(2) Appeal to the Federal Circuit. On appeal to the Federal Circuit, the government-appellant argued that the top
Luxembourg parent should be treated as a mere collection or remittance agent and that the other members of the
group should be treated as technical taxpayers based on the income they generated. The Federal Circuit rejected this
argument, holding in favor of the taxpayer and a literal reading of the technical taxpayer rule.
The Federal Circuit Court of Appeals, 477 F.3d 1368 (2007) upheld the consolidated corporation's refund claim
for FTC for Luxembourg taxes that affiliated Luxembourg co.(LC)/disregarded entity paid on behalf of itself and its
Luxembourg subsidiaries. Credit was allowable pursuant to 901 and Treas. Reg. 1.901-2(f)(l) where LC was the
person legally liable for tax within meaning of Luxembourg law. Government's argument that LC was merely remitting
agent, and that subs. were parties legally liable for stated taxes, was belied by Deputy Director of Luxembourg tax
authority's testimony and relevant tax law provisions *48 indicating that Luxembourg parent/LC was only entity that
existed for Luxembourg tax purposes and only it, not subs., could be liable for taxes. Similarly, government's argument
that legal liability should be determined on basis of which parties earned underlying income (i.e. subsidiaries) was
belied by foregoing authorities and fact that Treas. Reg 1.901-2(f)(1) contained no such earnings test.
(3) Issuance of Regulations and Later Congressional Action in Enacting Section 909.
(1) Proposed Regulations in 2006 to Treas. Reg. 1.901-2(f)(1). In response to the setback in the Guardian
Industries, supra, case, the IRS issued proposed regulations in 2006 denying technical taxpayer status to a company
that did not actually pay the foreign tax sought to be credited (REG 124152-06, 8/4/06) under 901 concerning
the determination of the person who paid a foreign income tax for FTC (2006 proposed regulations). The 2006
proposed regulations addressed what the Service and Treasury both regarded as the inappropriate separation of
foreign income taxes from the income on which the tax was imposed in certain circumstances. In particular, the
2006 proposed regulations provided guidance under Treas. Reg. 1.901-2(f) relating to the person on whom foreign
law imposes legal liability for tax, including in the case of taxes imposed on the income of foreign consolidated
groups and entities that have different classifications for U.S. and foreign tax law purposes.
(2) Enactment of Anti-Splitter Rules Under Section 909 in 2010. New Section 909 gives the Service broad
regulatory authority to implement the provision. It applies to taxes paid or accrued in a post-2010 taxable year (a
tax year other than a pre-2011 tax year). Section 909 was enacted as part of legislation commonly referred to as
the Education Jobs and Medicaid Assistance Act (EJMAA) on August 10, 2010 (Public Law 111-226, 124 Stat.
2389 (2010)).
Section 909 was enacted by Congress to combat what it considered to be inappropriate tax structures designed to
defer the realization of foreign source income while at the same time allowing a U.S. *49 taxpayer to accelerate
or realize FTCs with respect to the same foreign income. According to statutory language as interpreted by the
Explanation of the Staff of the Joint Committee on Taxation (JCT Report), to pre-2011 taxes for the purpose
of applying the deemed-paid foreign tax credit rules to dividends, deemed dividends, and 951 inclusions in a
post-2010 tax years. Section 909 was enacted in 2010 to suspend the FTC where the associated foreign tax and
the income to which it relates are separated (in a so-called splitter transaction). Section 909 provides that if
there is a foreign tax credit splitting event with respect to a foreign tax paid or accrued by a taxpayer or a
902 corporation, the tax is not taken into account for federal income tax purposes (such as 901 and 902 and
the determination of earnings and profits (E&P)) before the year in which the payor of the tax takes into account
the related income (or, for 902 corporation, related E&P). A foreign tax credit splitting event occurs when a
covered person (generally, a person related to, or connected through 10% ownership with, the payor of the tax)
takes the related income into account. The suspended tax is taken into account (or recaptured) in the tax year in which
the payor of the tax, (paid or accrued) or a 902 shareholder in the payor takes into account the related income (as
computed under U.S. principles).See discussion below in VII of this outline on the complex foreign tax splitter rules.
(3) Revised Final (and Temporary) Legal Liability Regulations. On February 14, 2012, the Service and the
Treasury issued Final and Temporary Regulations in T.D. 9756 (and T.D. 9757) on the legal liability test. The
Final Regulations, which became effective immediately upon issuance, adopt, with some modifications, portions of
the 2006 Proposed Regulations while other portions were withdrawn. On the same date the Service and the Treasury
issued Temporary Regulations on 909, T.D. 9577, the anti-tax splitter provision, which Congress enacted in 2010
to address what it considered to be the inappropriate separation of foreign income taxes and related income and the
timing for claiming FTCs on such (deferred) foreign source income. The Preamble to the Final *50 Regulations
stated that the Treasury Department and the IRS, however, are continuing to consider whether and to what extent to
revise or clarify the general rule that tax is considered paid by the person who has legal liability under foreign law
for the tax. For example, the Treasury Department and the IRS are continuing to study whether it is appropriate to
provide a special rule for determining who has legal liability in the case of a withholding tax imposed on an amount
of income that is considered received by different persons for U.S. and foreign tax purposes, as in the case of certain
sale-repurchase transactions.
Application of Legal Liability Rule to Foreign Consolidated Groups and Combined Income Regimes. The
Final Regulations under - 2(f)(1) of 901, with minor changes, the proposed rule that the foreign tax must be
apportioned among the persons whose income is included in the combined base pro rata based on each person's
portion of the combined income, as determined under foreign law. The Final Regulations generally adopt, again
with modifications and clarifications, the 2006 Proposed Regulations on when foreign tax is considered to be
imposed on the combined income of two or more persons. The Final Regulations go into substantial detail in
making the required calculations. The same adoption of the 2006 Proposed Regulations was made on determining
each person's share of the combined income tax base, with changes to reflect that certain hybrid instruments and
disregarded payments are to be treated as splitter arrangements subject to 909 such as with respect to
reverse hybrid arrangements. So consolidated or combined groups will still be subject to the 901 regulations
and not directly treated under 909.
Treatment of Partnerships and Disregarded Entities. The Final Regulations on legal liability for the payment
of foreign tax under -2(f)(1) adopt for the most part the *51 2006 Proposed Regulations treatment of partnerships
and disregarded entities. The Final Regulations apply the same foreign tax allocation rules for 708 terminations
per 708(b)(l)(A) for a partnership that has either: (i) ceased business operations; (ii) has undergone a change
in ownership termination; or (iii) has become a disregarded entity. The same is true with respect to applying the
other allocation rules under 706.
IV. THE INDIRECT FOREIGN TAX CREDIT
A. Background.
1. In General. The basic principle of the indirect tax credit is that it should not be more or less advantageous from a
U.S. federal income tax perspective to operate abroad through a subsidiary than it is through a branch. Thus, the profit of
a foreign subsidiary in the hands of its domestic parent corporation should have been subject to the same total tax burden
that the profit from the same operation conducted as a branch would be. The domestic corporation operating as a branch
would receive a direct foreign tax credit for the foreign income taxes the parent paid on the branch income. Equal treatment
for the branch and the subsidiary requires that the parent receive an indirect credit for the subsidiary's own income taxes
paid. Under 902, the domestic corporate shareholder is entitled to a credit against domestic income tax for the foreign
income tax paid by the foreign subsidiary. Under 78, the amount of foreign taxes paid by the payor is included in the
shareholder's gross income (the gross-up) in order to ensure that the same amount of tax is paid as would be the case if
the income were earned by a U.S. (or foreign) branch of the recipient shareholder.
2. Indirect Credit Example. USCO, which is subject to U.S. income taxation at a rate of 35%, owns 25% of the outstanding
stock of Forco; the balance of Forco's stock is owned by third-country residents unrelated to USCO. Forco earns $500x of
income in its home country and bears a 20% local tax on that income. Forco then distributes its remaining $400x of earnings
to its shareholders, net of a 10% withholding tax; USCO receives cash of $90x ($400x - $40 withholding tax = $360x;
$360x * 25% = $90x). The tentative U.S. tax on the dividend is $35x ($90x cash * 35% = $25x, plus $10x withholding
tax), which (before application of the indirect credit) would be offset by a foreign tax credit of $10x for the withholding
tax on USCO's share of the distribution, yielding a final U.S. tax of $25. USCO *52 is also entitled to an indirect credit
for its pro rata share of Forco's foreign income tax paid with respect to the distributed income ($100x * 25% = $25x).
If USCO had earned $125x directly from U.S. sources, its total tax would equal the U.S. tax burden of $43.75x ($125x
* 35%). If USCO were deemed to have earned only $100x from Forco, its U.S. tax burden would be $0x ($100x * 35%
= $35x, reduced by a direct credit of $10x and an indirect credit of $25x) and its aggregate burden would only be $35x
(the sum of the two foreign taxes). By including the amount of the indirect foreign tax in USCO's income as a dividend,
the U.S. burden increases to $8.75x ($125x *35% = $43.75x, reduced by $35x of direct and indirect foreign tax credit),
and USCO's aggregate tax burden rises to $43.75x - the amount USCO would have owed if all of the income were from
U.S. sources and free of foreign tax.
B. Requirements for the Indirect Credit.
1. Corporate Recipient. The shareholder claiming the 902 indirect FTC must be a corporation. Historically, there was
some uncertainty as to whether a corporation owning its interest in the foreign payor through a partnership was entitled to
the indirect FTC, although the weight of authority and analysis suggested that it should be. See Rev. Rul. 71-141, 1971-1
C.B. 211. AJCA 2004 confirmed the availability of the FTC in such a case from October 22, 2004 forwards. Foreign taxes
paid by a single-member limited liability company wholly owned by a U.S. corporation should qualify for the indirect FTC,
since such LLCs are treated as branches of their owners for U.S. federal tax purposes. Whether an entity is a corporation or
a partnership is determined under the so-called check-the-box regulations. Under Treas. Reg. 301.7701-2(b)(8), certain
types of foreign business entities set forth on a per se list are deemed to be corporations for U.S. tax purposes. Foreign
eligible entities, that is, foreign business entities that are not per se corporations, are assigned a default classification
under the regulations. Eligible entities that are not satisfied with their default classification may elect classification as either
a corporation or a pass-through entity. An entity that elects pass-through status is treated as a partnership if it has more
than one member and is disregarded as an entity separate from its owner (a deemed branch) if it has only one member.
A grandfather rule provides continued pass-through treatment for certain preexisting foreign entities on the per se list
that had a reasonable basis for claiming pass-through status. Treas. Reg. 301.7701-2(d). The default classification of a
foreign entity in existence before Jan. 1, 1997 (and whose classification was relevant for U.S. federal tax or information
purposes at any time during the 60 months before that date) will be the classification it claimed under the prior regulations.
The regulations also provide for any declassification claimed under the prior regulations and default rules for *53 foreign
entities that do not meet this grandfather rule. Under these rules, a foreign entity that has two or more members, at least
one of which does not have limited liability, is a partnership for U.S. tax purposes in the absence of a contrary election. A
single-member entity without limited liability is disregarded as an entity separate from its owner for U.S. tax purposes in
the absence of an election of corporate status. Finally, a foreign business entity all of whose members have limited liability
is a corporation for U.S. tax purposes absent a contrary election. Treas. Reg. 301.7701-3(a).
a. Pass Through Eligible Entities. Pass through entities, including branches, are not subject to 902. Instead the foreign
income taxes paid by such entities will be treated as if paid directly by the partnership and the single owner with respect
to a deemed branch. A deemed liquidation of a first tier foreign subsidiary may also cause the FTCs to be claimed by
the parent domestic corporation under 901. See Dover Corporation v. Comm'r, supra.
b. Six Tier Subsidiary Limitation. Foreign tax credits under 902 and 960 are not available for taxes attributable to
dividends paid by lower-than-sixth-tier corporations. The use of foreign entities that can be treated as deemed branches
effectively allows a U.S. shareholder to extend the indirect credit to qualified taxes paid by such lower-tier entities.
c. Allocation and Apportionment of Interest Expense. In calculating foreign source income for purposes of the 904
foreign tax credit limitation, interest expense is generally allocated between domestic and foreign source income based
on the proportion of the U.S. corporation's (or consolidated group's) assets that generate the specific type of income.
In performing this allocation, the stock of a foreign corporate subsidiary is included in determining the parent's assets.
However, interest paid by a foreign subsidiary is not included in this allocation. Use of a foreign partnership or deemed
branch, in contrast, allows the U.S. corporation to take account of its allocable share of the foreign pass-through entity's
assets and interest expense. The effect of this inclusion may be to substantially increase the U.S. corporation's foreign
tax credit limitation as compared with the foreign corporate subsidiary situation.
2. Interest in Foreign Taxpaying Corporation. Under 902, the domestic corporate shareholder receives an indirect
foreign tax credit from foreign corporations only if the corporate shareholder owns at least 10% of the voting stock of the
foreign corporation issuing the dividend. The ownership must be actual (not constructive) ownership (though it need not
be direct), and the interest cannot be dispersed among members of a *54 consolidated group. However, the indirect FTC
can be applied through six tiers of foreign corporations.
3. Dividend. In order to claim an indirect tax credit, the domestic corporate shareholder must have received an actual or
constructive dividend from the foreign corporation. Section 316 defines a dividend as any distribution by a corporation to
its shareholders from earnings and profits. Because of the wholesale amendments to the FTC system introduced in 1986,
it is critical to account for the foreign distributor corporation's pre-1987 and post-1986 earnings and profits separately. In
addition, because of the basket system in effect under the 904 limitation (see below), earnings and profits (and the
foreign taxes they are deemed to have borne) must also be allocated among the relevant baskets. This implies a good deal
of operational complexity.
a. Payment of Actual Dividends. A dividend is defined for indirect FTC purposes by cross-referencing to the general
dividend definition in Subchapter C. Section 316 defines a dividend as a corporate distribution out of earnings and
profits, a term of art that is only incompletely defined in 312. (Many of the real-world difficulties encountered in the
day-to-day management of the FTC revolve around the need to translate foreign accounting income into U.S. earnings
and profits.)
b. Dividend Analogues and Constructive Dividends. Dividend tax treatment may result from transactions in which
shareholders receive economic value without adequate compensation. Constructive dividends can also arise from the
required accrual of income from certain foreign corporations having one or more U.S. shareholders. For constructive
dividend treatment, intent to distribute a dividend is not necessary: the transfer ultimately classified as a dividend can
initially be classified as a loan, a business expense, or consideration for the acquisition of an asset. The Code automatically
treats as a distribution (with dividend potential) the following transactions involving foreign corporations:
(1) Subpart F Inclusions: Sections 960 and 962. Section 951 requires a U.S. shareholder of a controlled foreign
corporation (CFC) to take into income on an accrual basis the shareholder's pro rata portion of certain types of
income earned by the CFC such as Subpart F income. The inclusion itself is not a dividend for most tax purposes
and does not reduce the CFC's earnings and profits, but 960(a) supplies dividend treatment for the limited purpose
of delivering indirect FTCs to U.S. shareholders. U.S. shareholder of a CFC that is an individual is subject to the
*55 income inclusion rules of Subpart F, but generally cannot claim the 960 indirect credit, which is reserved to
corporations. Under 962, however, a U.S. individual shareholder of a CFC can elect to be taxed with respect to the
CFC as if he or she were a U.S. corporation. If this election is made, the U.S. individual can claim the indirect credit
under 960 to the same extent as if he or she were a U.S. corporation.
(2) Section 1291 Deferral Rules and Indirect Foreign Tax Credits. Section 1291 governs the taxation of a U.S.
shareholder of a passive foreign investment company (PFIC) that is not a qualified electing fund (QEF) with
respect to that shareholder. Under 1291, excess distributions from a PFIC and gains from dispositions of PFIC
stock are allocated ratably over the U.S. shareholder's holding period for the PFIC stock. A deferred tax amount is
imposed on amounts allocated to periods before the taxable year of the distribution or disposition. Under 1291(g),
the deferred tax amount may be reduced by a special indirect credit for foreign taxes paid or deemed paid by the PFIC.
(3) Section 1293 Current Income Inclusions and Foreign Tax Credits. A U.S. person owning owns shares in a passive
foreign investment company (PFIC) and making a qualified electing fund election with respect to that company
must include as income separately a pro rata portion of the company's ordinary earnings (earnings and profits not
attributable to net capital gain) and of its net capital gain. Section 1293(f) treats those inclusions as Subpart F inclusions
for purposes of applying 960(a).
(4) Application to Domestic International Sales Corporations (DISC). Although a DISC is a U.S. corporation,
901(d) provides that certain dividends from a DISC or former DISC are treated as dividends from a foreign corporation
for purposes of the FTC rules. Where the earnings of the DISC or former DISC were subject to foreign taxation, the
dividends may generate an indirect credit under 902. This is an exception to the general rule that an indirect credit
is available only for taxes paid by a foreign corporation
c. Application of Section 902 and Section 1248. Under 1248, a U.S. person that sells, exchanges or distributes the
stock of a CFC or former CFC may be required to treat part or all of the gain as a *56 dividend. A 902 indirect credit
may be available for this deemed dividend to a 10% or more voting shareholder of the CFC.
d. Application of Section 902 and Section 367. Under 367, a U.S. shareholder that receives a distribution in liquidation
of a foreign corporation, or that exchanges the stock of a foreign corporation in a reorganization, may be required to
recognize a dividend. A 902 indirect credit may be available for this deemed dividend if the requirements are satisfied.
e. Sales Recharacterized as Dividends. Sale-type transactions receiving dividend treatment in the U.S. tax law include:
(1) Section 302 Redemptions. A distribution in redemption of stock will be treated as a distribution of property to
301 applies if the distribution is not within any of the provisions of 302(b). In that event the distribution will be
treated as a dividend to the extent of the distributing corporation's available earnings and profits from the current year
and earlier post-1913 taxable years.
(2) Section 304 Redemptions or Sales. When the controlling stockholders sell the stock of a corporation, gain on
a sale of stock of a corporation may be recharacterized as a distribution and 302 or 301 applies. If Section 301
applies, the constructive distribution is treated as a dividend to the extent of the joint earnings and profits of the target
and the acquirer. See August, Regulations Prevent Tax Avoidance From Stock Sales Between Related Corporations,
Business Entities (WG&L), Mar/Apr 2013.
(3) Section 1248 Dispositions. When a U.S. shareholder sells stock of a CFC, the gain is recharacterized by 1248(a)
as a dividend to the extent of the seller's pro rata share of the controlled foreign corporation's post-1962 earnings and
profits. See Notice 2012-15, 2012-9 IRB 424. New Guidance for Cross-Border Stock Transfers, 2012 TNT 75-6.
See also Parillo, Practitioner Suggests GRA-Lite Approach for Cross-Border Stock Transfers, 2012 TNT 116-5
(compliance and administrative burdens associated with Notice 2012-15 would be reduced by allowing a GRA-lite
filing for reporting both Sections 304 and 367 transactions in lieu of the normal multi-page, multi-informational GRA;
a GRA-lite would describe the Section 304 transaction, provide the fair market value of the issuer's *57 shares on
the date of the transfer, and have a two-year term (rather than a five-year term)).
V. THE SECTION 904 LIMITATION
A. Purpose of the Section 904 Limitation.
The purpose of the Section 904 limitation is to limit the credit in any year to the amount of U.S. tax otherwise payable on
foreign source income. Thus the effective rate of tax on the foreign source income of a U.S. taxpayer is the higher of the U.S.
or the foreign rate. Credits for foreign taxes in excess of the limitation can be carried back to the previous taxable year and
forward to the succeeding ten taxable years and forward one year. If foreign tax rates consistently exceed U.S. effective tax
rates, however, excess credits eventually expire unused and are wasted.
B. Overview of the Baskets.
Taxpayers must assign foreign source income to a basket or category of income. The taxpayer is entitled to a foreign tax
credit on the income in any one basket by the foreign taxes paid on the income in that particular basket. For years beginning
after December 31, 1986 and before January 1, 2007, the baskets were: (1) passive income, (2) high withholding tax interest,
(3) financial services income, (4) shipping income, (5) dividends from a noncontrolled Section 902 corporation, (6) dividends
from a DISC or former DISC, (7) taxable income attributable to foreign trade income, (8) certain distributions from an FSC
or former FSC, (9) oil and gas income, and (10) other income. For taxable years beginning after December 31, 2006, AJCA
2004 consolidated these baskets into two -- passive and general.
C. The Limitation in Action: A Hypothetical Case.
USCO earns $100x of general limitation basket taxable income in Country Z and has $200x of total income taxable by the
United States, including the foreign income. USCO pays $55x of income taxes to Country Z and incurs a pre-credit liability of
$90x for US taxes. USCO has no other foreign-source income. Under the limitation provisions of I.R.C. 904(a), the foreign
taxes that may be credited in any one year may not exceed the amount that keeps the proportion of foreign taxes to total taxes
equal to the foreign taxable income from Country Z to the total taxable income, i.e., 1:2. The maximum tax credit is thus $45x.
D. Current Principles of the Limitation.
The foreign credit limitation of 904 is needed to prevent a taxpayer from using foreign taxes to decrease U.S. taxes on
U.S. source income. The effect is to limit the credit in any year to the aggregate amount of U.S. tax on foreign source *58
income. It is not the case that only specific foreign taxes imposed on individual items of foreign-source income are eligible
for the credit.
E. Determining the Baskets.
Taxpayers must allocate foreign source income and related income taxes to various categories of income that have come to
be called baskets. The effect of that classification is to limit the taxpayer's potential foreign tax credits because high-taxed
income in one basket cannot be combined with low taxed income in another basket.
1. Pre-2007 Tax Years (Before AJCA 2004 Amendments).
a. Passive Income. Passive income is income which would be Subpart F foreign personal holding company income
if earned by a CFC. It also includes gain on a sale or exchange of stock in excess of the amount treated as a dividend
under 1248 (relating to sales of CFC stock), (2) amounts included in income under 1293 relating to certain PFICs,
and (3) related person factoring income that is treated as interest.
Passive income does not include any income for which another separate limitation category is prescribed, such as high
withholding tax interest. In addition, (1) related-party, same-country dividends and interest are generally not passive
income if they meet the requirements for exclusion from foreign personal holding company income under the Subpart
F rules applicable to CFCs; (2) distributions of previously taxed income, although treated as dividends for some purposes
(e.g., the distributing CFCs earnings and profits are reduced by the amount thereof), are not passive income; (3) most
export financing interest (see below) is excluded; (4) in the case of commodities transactions, qualified hedging
transactions do not generate passive income; and (5) rents and royalties received from an unrelated person in the course of
an active rental or licensing business can qualify as general limitation income if they meet the requirements for exclusion
from foreign personal holding company income under the Subpart F rules applicable to CFCs.
Income otherwise belonging in the passive basket will be kicked out into (usually) the general limitation basket if it
bears foreign tax at a rate in excess of the maximum U.S. federal tax rate. There are extensive rules for grouping different
items of income together in order to average the foreign tax rates that the items are subject to for purposes of the kick-out.
*59 b. High Withholding Tax Interest. High withholding tax interest is any interest other than export financing
interest subject to a withholding or other gross basis tax of a foreign country or U.S. possession at a rate of at least
5 percent.
A word is appropriate here on export financing interest, which is a favored item under the basket regime. Such
interest is defined as interest derived from financing the use or consumption of property outside the United States if
that property (1) is comprised of no more than 50% imported materials and (2) is manufactured, produced, grown or
extracted in the United States by the taxpayer or a related person. For a financial services entity, export financing interest
is usually financial services income (even if it fits the general definition of high withholding tax interest). For others,
export financing interest is generally general limitation income unless it also qualifies as a related person factoring
income, in which case it is usually classified as passive income.
c. Financial Services Income. Financial services income is relevant to persons predominately engaged in the active
conduct of banking, financing or similar business, or derived from an insurance company's investment of its unearned
premiums or reserves which is ordinary and necessary for the conduct of its insurance business. It also includes any
income which would be Subpart F insurance income, but without regard to where the insured risk is located and passive
income from the active banking business. Persons are predominantly engaged in the active conduct of a financing
business for any year if for that year 80% of their gross income is financial services income.
d. Shipping Income. Shipping income is any income that would qualify as Subpart F foreign base company shipping
income other than dividends from a noncontrolled Section 902 corporation or financial services income.
e. Dividends Received From Noncontrolled Section 902 Corporations.
(1) First (Pre-2003) Rules. Prior to the enactment of the Taxpayer Relief Act of 1997, dividends received by a
corporation from a noncontrolled Section 902 corporation (sometimes referred to as a 10/50 company) (1) that
was not a CFC and (2) in which the recipient owned at least 10% of the stock (by voting power) were subject to a
particularly onerous limitation. Dividends received from each 10/50 company in which the taxpayer had the requisite
stock interest were allocated to a separate basket; *60 no cross-crediting between multiple 10/50 companies was
allowed. This rule survived the enactment of the Taxpayer Relief Act of 1997, but only for taxable years beginning
before January 1, 2003.
(2) Second (Post-2002) Rules. Under the Taxpayer Relief Act of 1997, for taxable years beginning after December
31, 2002, and modified by AJCA 2004, the treatment of dividends from 10/50 companies is substantially altered. The
nature of the modification varies with the vintage of the 10/50 company's earnings and profits being distributed; for
new earnings, the new regime applies a look-through rule much like one applicable to CFCs (discussed below).
f. Dividends from DISCs and Former DISCs. Dividends paid by a DISC or a former DISC are subject to a separate
limitation amount to the extent those dividends foreign-source.
g. Distributions from FSCs and Former FSCs. Separate limitations apply to two categories of non-exempt foreign trade
income: (1) taxable income attributable to foreign trade income at the FSC level, and (2) distributions from an FSC or
former FSC out of earnings and profits attributable to foreign trade income.
h. Foreign Trade Income. Congress did not want the targeted U.S. tax rate on foreign trade income to be reduced by
excess foreign taxes on other general limitation income earned by the FSC, so it created a separate limitation category for
foreign trade income earned by a FSC. The result is that only foreign source effectively connected non-exempt foreign
trade income from nonadministrative pricing will be assigned to a FSCs foreign trade income limitation category. Under
I.R.C. 906(b)(5), the FSC will not be allowed to take a foreign tax credit for any foreign taxes paid on that income.
i. Other Income. All other income (which in operation constitutes the majority of foreign income) falls into the general
limitation basket.
j. Look-Through Rules. The look-through rules apply to payments made or deemed made by a CFC to one or more
of its U.S. shareholders. The rules deal with Subpart F inclusions, dividends, interest, royalties and rents which the CFC
may pay or accrue to a U.S. shareholder. Subpart F inclusions are allocated to the various baskets into which the CFCs
income that generated the dividend fell. If the dividend from the CFC is another kind of dividend, a dividend arising from
an investment by the CFC in U.S. property *61 or a dividend arising from the sale of the U.S. shareholder's stock in
the CFC, then the same look-through rule described above applies, but, because the dividend may come from historical
earnings, the U.S. shareholder must apply a formula to determine the ratio of income to each basket in the hands of the
CFC from which the dividend is taken.
k. Other Operating Rules. Losses, earnings and profits and foreign taxes are all allocated and attributed to appropriate
baskets under an extensive set of highly technical rules elaborated in the Treasury Regulations. For purposes of
interleaving the Subpart F rules with the FTC baskets, (i) foreign base company sales and services income is generally
characterized as active income that will fall into either the general or financial services baskets; (ii) foreign base company
shipping income is attributed to the shipping basket; and (iii) foreign personal holding company income is attributed
to the passive basket (except for high withholding tax interest, financial services income, kicked-out income, 10/50
dividends, active rents and royalties and export financing interest).
2. Post-2006 Tax Years (After AJCA 2004 Amendments). As previously noted, AJCA 2004 replaced the foregoing
regime with a greatly simplified, two-basket system. The 10/50 basket was essentially assimilated to the CFC look-
through rules on a largely retrospective basis. The remaining baskets were consolidated into two new categories of income.
a. Passive Category Income. Passive category income contains the items formerly assimilated to the passive income
basket, as well as most high withholding tax interest, DISC and FSC items and (nor non-financial institutions) financial
services income.
b. General Category Income. All items of income not included within the ambit of the passive income category are
placed in the general category. Among other things, this has the effect of repealing the former shipping basket.
F. Calculating the Foreign Source Taxable Income-Domestic Taxable Income Ratios.
The Section 904 limitation is equal to the taxpayer's foreign source taxable income multiplied by the ratio of the taxpayer's
tentative (i.e., pre-FTC) U.S. tax to the taxpayer's entire taxable income. This ratio is the effective rate of U.S. tax. The credit
is the lesser of (1) the foreign income taxes paid or (2) the limitation (foreign source taxable income multiplied by the effective
U.S. rate). It is important to recall that the income in each case is taxable income, so deductions (apportioned between U.S.
and foreign sources, and among items in various *62 baskets, according to complex rules contained in the regulations under
861) must be taken into account before applying the ratios.
VI. SERVICE'S ATTACK ON FOREIGN TAX GENERATORS: WHAT IS THE PROPER APPLICATION OF THE
ECONOMIC SUBSTANCE DOCTRINE TO FOREIGN TAX CREDITS
A. Application of the Economic Substance Doctrine to Federal Tax Credit Planning.
1. Fundamental Principle of Federal Income Tax Law. See, in general, August, The Codification of the Economic
Substance Doctrine, Parts I and II, 12 BET 5 (September/October 2010)) 12 BET 6 (November/December 2010).
a. Business Purpose Doctrine. The business purpose prong of the economic substance doctrine, requires that the
taxpayer, in entering into the transaction, was motivated by a bona fide business purpose and not simply by tax advantages
or tax savings. The business purpose test involves an inquiry into the subjective motives of the taxpayer to determine
whether the taxpayer intended the transaction to serve some useful nontax purpose or purposes. A transaction lacks
business purpose when there is no independent non-tax purpose for the transaction, other than tax savings.
The business purpose doctrine was first announced by the Supreme Court in Gregory v. Helvering, 55 S.Ct. 266
(1935). This doctrine was then cited by the Second Circuit in Comm'r v. Transport Trading & Terminal Corp., 38 AFTR
365, 176 F.2d 570 (2nd Cir. 1949) as having far broader application than simply to recast an attempted reorganization
into a corporate level asset sale as was the factual setting in Gregory v. Helvering, supra:
The doctrine of Gregory v. Helvering, which we here hold to be controlling, is not limited to cases of corporate
reorganizations. It has a much wider scope; it means that in construing words of a tax statute which describe commercial
or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial
purposes and not to include transactions entered upon for no other motive but to escape taxation. 176 F.2d @572.
b. Economic Substance Doctrine. The economic substance test requires, inter alia, that there be a meaningful change
in the taxpayer's economic position other than simply reducing its tax burden. The economic substance test provides
that the tax benefits from a transaction or a series of transactions will not be realized by *63 the taxpayer where the
underlying transaction or series is without economic substance, i.e., a real change in the taxpayer's economic position
independent of federal income tax considerations. A real change in economic position invariably focuses on whether
there is a realistic possibility that the taxpayer will derive a profit from the transaction. When a transaction lacks
economic substance, the form of the transaction is disregarded in determining the proper tax treatment of the parties to
the transaction. The Supreme Court has held that transaction that is entered into primarily to reduce taxes and that has no
economic or commercial objective will not be given effect for federal income tax purposes. U.S. v. Knetsch, 364 US 361
(1960)(interest deductions for interest paid on debt instruments disallowed; in substance held the funds purportedly
borrowed from the issuer did not constitute a bona fide debt).
A multi-factor formulation of the economic substance doctrine was set forth in Coltec Industries. Inc.. 454 F.3d 1340
(Fed. Cir. 2006) vac'g and rem'g 94, 62 Fed Cl 716 (2004), cert. den.127 S. Ct. 1261 (2007). Factors identified by the
Federal Circuit that the courts have used to determine whether a transaction should be disregarded for tax purposes based
on the absence of economic substance include:(l) the transaction must have economic reality; (2) the taxpayer must
prove the transaction had economic substance (i.e., involved a real change in the (nontax) risks and benefits between the
parties); (3) the economic substance must be real (i.e., based on an objective standard, and not the taxpayer's belief as
to economic reality); (4) the specific transaction that produces the alleged tax benefit must be examined separately where
it is one step in a series of steps in a multi-step transaction; and (5) transactions that do not affect the economic interests
of unrelated third parties must be carefully scrutinized. The Coltec court noted that if a court finds that a transaction is
wholly lacking in economic reality so that no realistic financial benefit inures to the taxpayer beyond the tax features, or
that no reasonable possibility of profit is present, the court need not engage in the subjective inquiry as to the business
purpose test.
c. Satisfaction of Either Business Purpose or Economic Substance Tests or Both?l. Either or Both Factors Test: Split in
the Circuit Courts of Appeals Prior to the Enactment of Section 7701(o). Prior to Section 7701(o), there was a split among
the circuit courts of appeals on whether the conjunctive or a disjunctive test was required to respect the substance of
a transaction for federal income tax purposes. The Third, Fifth, Sixth, Eleventh, and Federal Circuits applied a two-prong
conjunctive test which requires the taxpayer to establish both objective economic benefit *64 and subjective business
purpose before a transaction will be given substance for federal tax purposes. The Fourth and Eighth Circuits, by contrast,
required that only one prong be satisfied by the taxpayer in order for it to prevail. A third approach, taken by the Ninth and
Tenth Circuits, employed an all factors approach in determining whether the transaction should be granted substance.
2. Codification in Section 7701(o). Section 7701(o), which was enacted into law as part of the Health Care and Education
Reconciliation Act of 2010, sets forth a statutory definition of the economic substance doctrine as well as a draconian
penalty for a taxpayer's failure to meet the statutory rules. As mentioned, the common law doctrine of economic substance,
which continues to have application despite the enactment of 7701(o), may be summarized as a principle applied by the
courts to deny taxpayers tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's
economic position other than a purported reduction in federal income taxes. It can be applied where the IRS and, if litigation
ensues, the court believes that a transaction and its projected tax consequences, including associated costs and expenses,
should be disregarded for tax purposes. While there was some debate on whether a further ad terrorem provision was
needed, Congress nevertheless acted. See, in August, Codification of the Economic Substance Doctrine, Parts I and II,
supra.
a. Penalties. Violation of 7701(o) will frequently result in a penalty of 40% of the tax owed on the resulting deficiency.
and seek to impose the strict liability, in terrorem penalty of 40%. Penalties for violating 7701(o) are contained in
6662(b)(6), which imposes a 20% accuracy relating penalty, and 6662(i)(l), which increases the penalty to 40%
where the position in issue was not disclosed on the return or otherwise in a timely manner. Under 6664(c)(2), there is
no reasonable cause exception with respect to an understatement attributable to the lack of economic substance in a
transaction. That is, there is strict liability for the penalty if the statutory prescription of economic substance is violated.
b. Impact of Section 7701(o) on Mainstream Business Transactions. In response to 7701(o)'s enactment, some
commentators voiced concern that the characteristics of new 7701(o) could jeopardize the intended tax benefits
anticipated from many customary business transactions, that were specifically permitted by statute, or would result in
transactions being left on the shelf for fear of the possible reaction by the IRS. The legislative history to 7701(o) recites
that the codification of economic substance only represents a clarification of existing law: No inference is intended
as to the proper application of the *65 economic substance doctrine under present law. The provision is not intended
to alter or supplant any other rule of law, including any common-law doctrine or provision of the Code or regulations
or other guidance thereunder; and it is intended the provision be construed as being additive to any such other rule of
law. Despite the sound arguments expressed by codification opponents, Congress showed its frustration with certain
taxpayers, their advisors, and tax strategy promoters when it enacted Section 7701(o) and the 40% penalty for undisclosed
positions or transactions that do not have economic substance.
3. Foreign Tax Credit Cases Involving Economic Substance and Business Purpose Doctrines.
a. Foreign Tax Credit Generators: Background. (See preceding portion of this outline page 24, supra). The Internal
Revenue Service, Chief Counsel's Office and the Department of Justice, Civil Tax Division, have determined in recent
years that financing arrangements purposely designed to generate or yield FTCs as a material economic incentive for
entering into the arrangement should be attacked on the basis that such arrangements do not have economic substance. See
discussion above on the Guardian Industries, supra, case. Recent judicial victories enjoyed by the Service are somewhat
surprising given the facts in each case which demonstrate that the taxpayers met the formal requirements of the Code,
actually incurred and paid the foreign tax involved and understanding the policy rationale for Congress' enacting 901.
The transactions involved may be identified as falling within two general contexts or scenarios.
(1) Scenario One: Foreign Subsidiary of U.S. Parent Corporation. A common fact patterns involves a U.S. borrower
engaged in business operations in the foreign lender's country through a wholly-owned, foreign subsidiary. The foreign
subsidiary borrows funds from the foreign lender by issuing to it preferred shares or other species of equity in the
subsidiary instead of a debt instrument. The dividends paid to the foreign lender, a substitute for what otherwise
would be interest, are neither deductible nor creditable for foreign income tax purposes. The arrangement permits,
however, the foreign lender to pay little or no tax on the dividends received perhaps under a special exemption
rule that is part of the foreign country's (domestic) tax laws. The foreign bank is willing to share some of its home
country tax savings derived from the participation exemption or other favorable provision with the U.S. borrower by
lowering the real *66 interest rate on the preferred equity. While the wholly-owned, foreign subsidiary's foreign
tax payments increase, the U.S. borrower also is permitted to claim indirect FTC under 902 for such incremental tax
obligation when and as dividends are repatriated to its U.S. parent corporation.
(2) Scenario Two: The Newly Formed Subsidiary. The U.S. borrower establishes a local country subsidiary in the
jurisdiction of the foreign lender and borrows funds from the foreign lender again in the form of a preferred stock or
equity in the newly created subsidiary. The loan proceeds are used to acquire assets of the U.S. parent corporation,
or, alternatively, loans the funds directly back to the U.S. parent. In this setting, the income generated from the assets
funded with the borrowing becomes subject to foreign tax without the benefit of a foreign interest deduction because,
again, the U.S. borrower borrows in a form that is nondeductible equity for foreign tax purposes. The foreign based
lender again benefits under a special exemption rule that is part of the foreign country's (domestic) tax law. Still, the
U.S. parent will be permitted to claim indirect FTCs under 902 on dividends from its subsidiary for such incremental
tax obligation.
(3) Example. Foreign Bank (FB) lends $500M to U.S. borrower at 5% per annum. Under the preferred stock structure,
however, FB saves taxes of $2M on the non-taxable dividends under its home law instead of interest income annually
during the loan term. Assuming the term is 10 years. FB saves taxes $20M. The U.S. borrower gets no deduction for
the interest. That costs $2M in added annual tax costs. (Assume 40% rate to both parties). To make the deal, FB allows
the interest rate to be set at 4% and shift some of the tax savings it enjoys to the U.S. borrower. Thus, FB saves taxes of
$1.6M annually or $16M over the 10 year term. The US borrower incurs additional income tax of $1.6M annually but
is entitled to a FTC on the taxes paid to the applicable jurisdiction in which its foreign subsidiary is located. Assume
the foreign tax rate is 40% as well, the parent corporation under 902 would, upon payment of dividends sufficient
to distribute out the related accumulated earnings and profits. The FTCs would provide a tax savings of $16M. So,
what's wrong with this? Plenty, according to the Internal Revenue Service. It would push to disallow the U.S. parent
corporation for claiming the indirect foreign tax credits. Its rationale would be that the FTCs, whether indirect or *67
direct, should be deducted in determining the profit motive under the economic substance test.
b. Compaq Computer Corp. v. Comm'r, 277 F.3d 778 (5th Cir. 2001), rev'g 113 T.C. 214 (Simultaneous Purchase
and Resale Transactions).
(1) Factual Setting. In Compaq Computer Corp., supra, the domestic corporate taxpayer had entered into a dividend-
stripping transaction that had the effect of accelerating the realization of FTCs in reducing its U.S. tax liabilities.
Compaq purchased approximately $890M of ADRs (American Depositary Receipts) in the Royal Dutch Petroleum
Company, which, prior to the date of purchase, had declared a dividend of $22M (but before the record date) as to the
ADRs, from a client of an investment firm that specialized in hedging transactions.
(2) American Depositary Receipt or ADR. An ADR is a trading unit, generally issued by a trust, that represents
ownership of stock in a foreign corporation. Foreign stocks are customarily traded on U.S. stock exchanges using
ADRs. Each ADR is issued by a domestic custodian bank when the underlying shares are deposited in a foreign
depositary bank, usually by a broker who has purchased the shares in the open market local to the foreign company.
An ADR can represent a fraction of a share, a single share, or multiple shares of a foreign security. The holder of a DR
has the right to obtain the underlying foreign security that the ADR represents, but investors frequently simply hold
onto and own the ADR. The price of an ADR generally tracks the price of the foreign security in its home market,
adjusted for the ratio of ADRs to foreign company shares. ADRs can be subject to excise or similar taxes. For example,
for companies domiciled in the United Kingdom, creation of ADRs attracts a 1.5% stamp duty reserve tax (SDRT)
charge by the UK government.
The ADR transaction involved in the Compaq case starts with the purchase of the ADRs with the settlement date at
a time when the purchaser is entitled to a declared dividend -- that is, before or on the record date of the dividend. The
transaction ends with the immediate resale of the same ADR with the settlement date at a time when the purchaser is
no longer entitled to the declared dividend -- that is, after the record date. In the terminology of the market, the *68
ADR is purchased cum dividend and resold ex dividend.
One day after the purchase, Compaq immediately sold the ADRs back to the same seller, ex dividend, through
the NYSE. The broker and investment firm's fees for the transaction were approximately $1.5M. Compaq was the
shareholder of record of the ADRs on the dividend record date and was therefore entitled to a gross dividend of about
$22.5M. About $3.4M in Netherlands tax was withheld from Compaq's dividend by Royal Dutch and paid over to the
Netherlands government. The net dividend, about $19.2M, was paid directly to Compaq. The $22M dividend received
by Compaq yielded an overall profit of $2M from the transaction. Compaq claimed a tax loss of $20M on the sale of
the ADRs since it sold back the ADRS without the right to the dividend. The $22M dividend was subject to a 70%
deduction under 243, and approximately $3.4M of foreign tax (Netherlands) was withheld on Royal Dutch's $22M
dividend payment. The taxpayer reported the Netherlands withholdings as FTCs, and it used the capital loss to offset
part of a capital gain of about $231.7M realized in the same year (1992) from the sale of stock in another company.
Overall, Compaq paid U.S. tax of $640,000 on the $22M million dividend (net of the dividends-received deduction),
and it claimed a FTC of $3.4 million.
Stated differently, the reduction in income tax received by the United States was not the result of a reduction in
income tax paid by Compaq. Each dollar of income tax paid to the Netherlands was just as real, and was the same
detriment to Compaq, as each dollar of income tax paid to the United States. Even Respondent's expert acknowledged
this detriment, and that Compaq's worldwide income tax increased as a result of the Royal Dutch ADR arbitrage.
A tax benefit can be divined from the transaction only if the income tax paid to the Netherlands with respect to
Royal Dutch dividend is ignored for purposes of computing income taxes paid, but is included as a credit in computing
Compaq's U.S. income tax liability. Such a result is antithetical to the foreign tax credit regime fashioned by Congress.
In the complete absence of any reduction in income tax, it is readily apparent that Compaq could not have engaged
in *69 the transaction solely for the purpose of achieving such an income tax reduction.
Petitioner's rationale is that it paid $3,381,870 to the Netherlands through the withheld tax and paid approximately
$640,000 in U.S. income tax on a reported pretax profit of approximately $1.9 million. (The $640,000 amount is
petitioner's approximation of U.S. income tax on $1.9 million in income.) If we follow petitioner's logic, however, we
would conclude that petitioner paid approximately $4 million in worldwide income taxes on that $1.9 million in profit
(3) Challenge by IRS. The IRS challenged the FTCs claimed by Compaq and imposed an accuracy-related penalty
for negligence.
(4) Tax Court Decision. The Tax Court agreed with the IRS and disallowed the gross dividend income, the FTC, and
the capital losses reported by Compaq on its return. It also disallowed Compaq's out-of-pocket expenses as deductions.
It further imposed an accuracy related penalty. Accuracy-related negligence penalties were upheld against U.S. corp.
that improperly claimed foreign tax credit for taxes withheld from dividend paid on American depository receipts
of foreign corp. it purchased and resold: although taxpayer's financial officers were sophisticated professionals with
investment experience, they didn't investigate transaction's details, entity to be invested in, parties it did business with,
or transaction's cash-flow implications.
The Tax Court ruled that the intention and effect of the transaction was to capture a tax credit, and not the ownership
of Royal Dutch ADRs, and that the transaction had been arranged so as to minimize any risks that might be associated
with the transaction. In other words, the transaction flunked the economic substance test. The Tax Court reasoned that
Compaq's ADR transaction had neither economic substance nor a non-tax business purpose.
*70 Tax Court: Compaq's Calculation of Alleged Profit. ADR transaction:
ADR purchase trades

($887,577,129)

ADR sale trades

868,412,129

Net cash from ADR transaction

($19,165,000)

Royal Dutch dividend

22,545,800

Transaction costs

(1,485,685)

Pre-Tax Profit

$1,895,115

Tax Court's Cash Flow Analysis: Computation of Compaq's Economic Loss (Without Foreign Tax Credit)
The following cash-flow analysis demonstrates the inevitable economic detriment to petitioner from engaging in
the ADR transaction:
Cash-flow from ADR transaction:

ADR purchase trades

($887,577,129)

ADR sale trades

868,412,129

Net cash from ADR transaction

($19,165,000)

Cash-flow from dividend:

Gross dividend

22,545,800

Netherlands withholding tax

(3,381,870)

Net cash from dividend

19,163,930

Cash Transaction costs

(1,485,685)

Net Economic Loss

($1,486,755)

*71 The Tax Court first concluded that Compaq had no reasonable opportunity for profit apart from the income
tax consequences of the transaction. The court reached this conclusion by employing a questionable calculation of
economic profit, i.e., what it called Compaq's net cash flow from the transaction. From applying this method the
Tax Court determined neither the transaction's pre-tax profitability nor its post-tax profitability. Instead, the Tax Court
assessed profitability by looking at the transaction after Netherlands tax had been imposed but before considering
U.S. income tax consequences. The Tax Court subtracted Compaq's $20.7M in capital losses, not from the $22.5M
dividend, but from the $19.2M net dividend (after taxes paid to the Netherlands). The Tax Court then ignored the
$3.4M FTC paid to the Netherlands on the dividend withholding tax. In other words, in determining whether the ADR
transaction was profitable, the Tax Court treated the Netherlands (foreign tax) tax as a cost of the transaction, but
did not treat the corresponding US FTC as benefit of the transaction. The result of this half pre-tax, half after-tax
calculation was a net loss figure of roughly $1.5 million. The Tax Court thus found that Compaq's purpose in entering
into the transaction was to capture FTCs, not substantive ownership of Royal Dutch ADRs, and that the transaction
had been arranged so as to minimize the risks associated with it. As for Compaq's business purpose, the Tax Court
concluded that Compaq was motivated only by the expected tax benefits of the ADR transaction.
(5) The Fifth Circuit Court of Appeals reverses the Tax Court: 277 F.3d 778 (5th Cir. 2001). Applied Two Part Test.
(a) Finding Economic Substance. The Fifth Circuit stated that in order to find that a transaction is a sham that
should not be recognized for income tax purposes, the court must find that: (i) the taxpayer was motivated by
no business purposes other than obtaining tax benefits in entering the transaction; and (ii) the transaction had no
economic substance because no reasonable possibility of a profit existed. The Fifth Circuit reversed the Tax Court
below and held that the transaction had both economic substance and business purpose whether the two-part test
was applied strictly or by looking at other factors. Thus, the Fifth Circuit has aligned itself with the majority of
circuit courts that have held *72 that a transaction lacks economic substance unless the taxpayer can satisfy both a
subjective test and an objective test. This conjunctive test is difficult to satisfy in the typical tax shelter transaction
where the fees associated with the investment dwarf any potential economic gain. The case involved tax years in
issue before the effective date of 7701(o).
(2) Government's Argument to the Fifth Circuit. The government argued that the Tax Court decision should be
affirmed on the lower court's determination that the transaction would not have been entered into by Compaq were
it not for the FTCs that it reported from the transaction. This demonstrated to the Service that FTCs were the item
that generated a tax-motivated transaction.
(3) Fifth Circuit, In Reversing the Tax Court, Follows 8
th
Circuit's Decision in IES Industries. The Fifth Circuit
noted first that the decision by the Tax Court below conflicted with the Eighth Circuit's decision in IES Industries.
Inc. v. United States, 253 F.3d 350 [87 AFTR 2d 2001-2492] (8th Cir. 2001). In IES Industries, the court held, as a
matter of law, that an ADR transaction identical to this one was not a sham transaction for income tax purposes. Based
on the two-part standard applied in Rice's Toyota World, the court declined to decide whether a transaction would be
a sham if either economic substance or business purpose, but not both, was present. Instead, the court concluded that
both economic substance and business purpose were present in the transaction before it. As to economic substance,
the 8th Circuit disagreed with the Service that the taxpayer purchasing the ADR acquired only the right to the net
dividend (net of foreign taxes paid) not the gross dividend. [T]he economic benefit to IES was the amount of the
gross dividend, before the foreign taxes were paid. IES was the legal owner of the ADRs on the record date. As
such, it was legally entitled to retain the benefits of ownership, that is, the dividends due on the record date. The
part of the gross dividend withheld as taxes by the Dutch government was as much income to the taxpayer as the
net dividend remaining after taxes. The court relied on the longstanding principle announced by the Supreme Court
*73 in Old Colony Trust Co. v. Comm'r, 279 U.S. 716, 729 (1929), that [t]he discharge by a third person of an
obligation to him is equivalent to receipt by the person taxed. Therefore, the foreign corporation's withholding and
payment of the Netherland tax is part of the income to the taxpayer, i.e., the gross dividend amount, and therefore
results in a profit to the taxpayer. When the full amount of the gross dividend was counted as income to the taxpayer,
the transaction resulted in a profit to the taxpayer. On business purpose, a subjective intent to avoid taxes by itself
will not determine whether there was a business purpose to the transaction. The Fifth Circuit rejected the Service's
argument that because the ADR transaction had little risk of loss to the taxpayer it should be regarded as a sham.
The Fifth Circuit followed the holding and reasoning of the 8th Circuit in IES Industries in reversing the Tax Court.
The Court opined that to un-stack the deck and include the FTC in calculating Compaq's after-tax profit from
the Royal Dutch transaction would not provide a windfall to Compaq. The FTC provisions are designed to reduce
international double taxation. Compaq reported its gross Royal Dutch dividend income to both the United States and
the Netherlands. Without the foreign tax credit, Compaq would be required to pay tax twice -- first to the Netherlands
through withholding on the gross dividend, and then to the United States -- on the same dividend income. Taking
the foreign tax credit into account, Compaq owed roughly $644,000 more in worldwide income tax liability as a
result of the transaction than it would have owed had the transaction not occurred. Although the United States lost
$2.7M revenues as a result of the transaction, that is only because the Netherlands gained $3.4M in tax revenues. If
the effects of the transaction are computed consistently, Compaq made both a pre-tax profit and an after-tax profit
from the ADR transaction. Subtracting Compaq's capital losses from the gross dividend rather than the net dividend
results in a net pre-tax profit of about $1.894M. Compaq's U.S. tax on that net pretax profit was roughly $644,000.
Subtracting $644,000 from the $1.894M million yields an after- *74 tax profit of $1.25M giving the transaction
economic substance.
c. Hewlett-Packard Company v. Comm,r, TC Memo 2012-135, RIA TC Memo 2012-135.
(1) Facts. This case involved a complex multi-party and multi-jurisdictional financing arrangement among
subsidiaries of America International Group, Inc. (AIG), Hewlett-Packard (HP), and ABN AMRO Bank N.V. (ABN),
a Dutch bank. The arrangement was created by a financial engineer employed by AIG-Financial Products Corp. (AIG-
FP) to take advantage of the asymmetric treatment of contingent interest in the U.S. and European countries, including
the Netherlands. The objective was to generate a stream of payments treated as preferred dividends and significant
foreign tax credits. In the initial step of the arrangement in this case, AIG contributed capital borrowed from ABN
to a newly formed foreign corporation (FOP) in exchange for preferred and common stock and warrants to purchase
additional stock. ABN then purchased common stock in FOP from AIG, and FOP used the contributed capital to
purchase contingent interest notes (CINs) issued by ABN. The CINs were issued in 1996 and had a maturity date of
12/31/06. Interest on the CINs consisted of fixed interest payable semiannually plus contingent interest (and compound
interest on the contingent interest) that was computed semiannually but was not payable until the 2006 maturity date.
Pursuant to a letter ruling obtained from the Dutch tax authorities, FOP included in gross income, and ABN deducted,
the contingent interest as it accrued. Most of the fixed rate interest on the CINs was intended to be distributed to holders
of the preferred stock as dividends in an arrangement that would generate significant indirect foreign tax credits for a
U.S. owner. The indirect foreign tax credits would effectively be supercharged as a result of differences in the way
the contingent interest was treated in determining the FOP's income subject to Dutch tax and in determining FOP's U.S.
earnings and profits. Additional agreements among the parties included; put and call agreements covering the warrants
and certain of the preference shares; a loan facility agreement between FOP and ABN to assure that funds would be
available to pay expenses and preferred dividends; a shareholders agreement under which FOP's business activities
were limited to acquiring and holding the CINs issued by ABN; the put and call options between the shareholders
that were *75 exercisable at fair market value in 2003 and 2007; a dividend reset feature beginning in 2003 that
operated to adjust the fair market value of the shares subject to the 2003 put option; and certain agreements with
respect to the management of FOP. After 2003, the Dutch taxes on contingent interest would begin to exceed the
actual interest that FOP received on the CINs. As a result, the options allowed the holder of the preference shares
to exit the arrangement at that time. Other contracts dealt with currency, interest rate, and tax risks. AIG offered HP
the opportunity to acquire certain of the preference shares in FOP. HP is a global company with large international
operations and, at the time of these transactions, was in an excess limitation position with respect to its foreign tax
credits. Before investing, HP performed a net present value analysis of the transaction that demonstrated that, if the
transaction with FOP did not generate foreign tax credits for HP, the FOP transaction would have a negative net present
value. In an after-tax scenario, however, the net present value of the transaction was approximately $57M. HP entered
into the transaction with FOP in 1996 by purchasing the class B preference shares and the class D priority shares from
AIG-FP for $202,569,004. This amount included a premium of more than $15M over the amount initially paid by
the AIG subsidiary for the shares in FOP. HP and AIG-FP negotiated a purchase price adjustment (a return of a portion
of the premium) if certain circumstances occurred, such as a change in the tax law.
(2) Taxpayer's Reporting Position. HP claimed direct and indirect FTCs under 901 and 902. It then exited the
arrangement in 2003, and claimed a $15M capital loss in the year of exit. The Service challenged the arrangement on
the grounds that: (i) HP's investment in FOP is more appropriately characterized as debt; (ii) HP's investment in FOP
was a sham under the economic substance doctrine; and (iii) FOP should be treated as a conduit entity under the step-
transaction doctrine, and the transaction should be recharacterized as a direct loan from HP to ABN.
(3) Service's Notice of Deficiency. Respondent issued two notices of deficiency to petitioner HP (and subsidiaries),
for 1999 and 2000 and for 2003, which, in part, disallowed foreign tax credits claimed for the tax years at issue, as
well as a S15.6M capital loss petitioner claimed for its 2003 tax year. The FTCs claimed were subject to limitations
and *76 were not actually used to reduce petitioner's Federal income tax liabilities for those years. Corresponding
adjustments to income under 78 did, however, increase petitioner's alternative minimum tax liabilities for all three
years in issue. Respondent did not reverse petitioner's 78 income in the notices of deficiency. The parties submit three
issues for decision: (1) whether petitioner's investment in the foreign entity Foppingadreef (FOP) is more appropriately
characterized as debt, rather than equity; (2) whether petitioner's investment in FOP was a sham under the economic
substance doctrine; and (3) whether FOP should be treated as a conduit entity under the step-transaction doctrine and
the transaction recharacterized as a direct loan from petitioner to ABN AMRO Bank N.V. (ABN).
(4) Tax Court Memorandum Decision, Judge Goeke. The court determined that the arrangement was debt rather
than equity and disallowed the capital loss for the sale by HP of its interest in FOP. The Court therefore decided it did
not need to address the other two grounds for challenge. The Tax Court in its opinion noted that the distinction between
debt and equity is basically whether there was an intent by the parties to create a debt with a reasonable expectation
of repayment. HP argued against integrating its put option into the overall transactions on the grounds that the option
was a contract between the shareholders and not between HP and FOP, the issuer of the preference shares. The court
disagreed and concluded that all agreements listed in the shareholders agreement (including the put option) were
properly treated as part of the overall arrangement. The court discussed the following factors: (i) although the labels
used by the parties to this transaction were not consistent with debt, the court held that the importance of this factor
was diminished in light of the substance of the overall arrangement; and (ii) the court held that HP's put option allowed
it to sell its shares to ABN in 2003 and thereby established the maturity date. The court reasoned that there was no
business or economic reason for HP to remain in the arrangement after 2003 and that the dividend reset agreement
effectively converted the fair market value of HP's preference shares to an amount that allowed HP to recover its
investment. In addition, the court found that the agreements effectively gave HP creditor's rights. While an equity
investment is subject to the risk of earnings, a creditor expects to be repaid its principal plus interest. The court held
that the arrangement effectively provided HP *77 with dividend payments equal to interest on its investment and
that HP was assured repayment of the principal amount at the end of the transaction. As to management participation,
the court noted that, while HP had basic voting rights in FOP, it did not value those rights except insofar as they
afforded HP a means to exit the arrangement. The court assigned little weight to this factor. As to the relationship of
the debt to other creditors, HP's investment was legally subordinate to the obligations of other creditors. Moreover, the
payment of dividends and the liquidation preference of HP's shares were legally subordinate to the claims of creditors
of FOP. Nevertheless, the court determined that, because FOP was prohibited from doing anything that would cause
the corporation to have a material creditor, HP had first claim to FOP's assets and that this claim was indicative of
the rights of a creditor. The Court found it was significant that HP had no intention to be subject to the risk of a joint
venture and intended to be repaid its investment in any event. The court conceded that an outside lender would not
have extended a loan on the same terms. The court went on: Nonetheless, HP's investment in FOP was premised on
the erroneous proposition that the FOP transaction would generate indirect FTCs under 902 rendering HP's return
on investment far more favorable. When accounting for the presumed FTCs, HP projected an after-U.S.-tax IRR on
its investment of 9.1%. The court then concluded that HP's investment in FOP should be treated as a loan for federal
income tax purposes. The IRS challenged the $15M capital loss claimed by HP on the ground that the loss amount
represented a fee paid to AIG-FP to participate in a tax shelter. The court held that HP had failed to meet its burden
of proof with respect to the proper characterization of the premium amount and the proper timing of the deduction.
The warrants were intended to cause FOP to be treated as a controlled foreign corporation under 957(a). The Tax
Court notes that a dual currency feature of the CINs allowed FOP to avoid the accrual of contingent interest for U.S.
tax purposes under rules in the then-outstanding proposed regulations.
d. Bank of New York Mellon Corporation v. Comm'r, 140 T.C. No. 2 (2013). The transaction involved a product
offered by a U.K. lender, Barclays Bank, referred to as a Structured Trust Advantaged Repackaged Securities (STARS)
transaction. It was a tax motivated program for U.S. borrowers of Barclays to be *78 advantaged by. BNY, with the
assistance of KPMG, came up with a structure to save U.K. tax. BNY, under the proposal would indirectly, through the
use of a trust, pay tax to the U.K. and receive a FTC. BNY could borrow money at a below-market rate when all of its
costs, net-after-FTC, were taken into account. The loan was most sizeable, approximately $1.5B.
(1) Facts. The plan involved BNY form a trust, create a subsidiary to hold assets contributed to the trust (Delco)
and form two new entities, Investco and NewCo to own interests in the trust. The assets BNY contributed were worth
over $7.86 billion. Barclays provided financing to BNY by acquiring two classes of interests (C and D) in the trust for
$1.5B in cash that was transferred to Barclays via redemption of Investco's interest in the trust. Barclays would receive
back its $1.5B in 5 years after its interest in the trust was redeemed. The trust paid yield to Barclays by a specific
return on the class D interest which from an economic perspective was interest. The trust had a U.K. trustee which
rendered the trust subject to U.K. income tax even though under U.S. law, the income was BNY's income. Barclays
received a determination from the U.K. tax authorities shortly after the formation of the trust that it would obtain U.K.
tax credits from the arrangement. Barclays was also entitled to a U.K. deduction for certain amounts paid to the trust.
So, the arrangement had Barclays benefitting (and at risk for) from the realization of U.K. tax benefits.
Barclays agreed to split or share its U.K. tax savings by reducing the interest paid by BNY by one-half of such
amount. BNY paid interest on the loan via distributions made to Barclays on the class D interests Barclays held
at a floating LIBOR plus 30 basis points then minus the spread. One of the costs involved was that BNY had to pay
U.K. tax (through the trust) on the income earned on assets it contributed to the trust. The FTCs were derived through
application of the grantor trust rules since BNY was the grantor and was also taxable on its income. By virtue of the
FTCs BNY claimed, it paid less for the use of $1.5B for the five year period it would have paid if it had borrowed
such amount at market rates. The IRS challenged the STARS program and disallowed Barclays': (i) claim of FTCs; (ii)
deductions for transactions expense: and (iii) whether BNY's income from the transaction was indeed foreign source
income as BNY claimed. The principle *79 argument was that the STARS program lacked economic substance, i.e.,
BNY should be denied the FTCs.
(2) Tax Court Decision: Still Relying on Compaq Computer. The Tax Court, in applying its Golsen Rule of judicial
administrative convenience, employed the Second Circuit's standard used in economic substance cases as the flexible
standard which applied both subjective business purpose and objective economic substance. Since the case was not
appealable to the Fifth Circuit, the Tax Court did not apply Compaq Computer, supra. This is effectively the standard
used in 7701(o) enacted into law in 2010. Still the years involved in the case were 2001 and 2002, well before
the Health Care law was enacted. As to economic substance, the Tax Court concluded that STARS did not create a
reasonable opportunity for an economic profit absent tax considerations. The court ignored the assets employed by
BNY in the transaction since it found that BNY had not lost control and management over the assets as a result of the
transfers made. Stated differently, the assets would have generated the same rate of return to BNY had the transfers in
trust not been made. A critical aspect of the Tax Court's opinion is contained in a footnote which stated that foreign
income taxes are treated as a cost for calculating a pre tax profit under the economic substance test. The Tax
Court cited its decision in Compaq Computer, supra, 113 T.C. 214 (1999) which was overruled by the Fifth Circuit,
277 F.3d 778 (2001) and the Eighth Circuit in IES Industries, Inc. 253 F.3d 350 (8th Cir. 2001) as authority for treating
FTCs as a cost for this purpose.
As to a substantial non-tax business purpose, it was quite obvious that BNY would contend that the lower loan costs
Barclay's charged was enough to meet this test. The Tax Court rejected this contention on the basis that the structure
lacked any reasonable relationship to a loan and that the loan was actually overpriced. The STARS program, to the
Tax Court, was motivated solely to achieve tax avoidance goals. The Court conceded that the STARS structure needed
to be taken into account if it resulted in lower borrowing courts but still it found that the non-FTC generated loan cost
was above prevailing interest rates. Since the transaction lacked economic substance BNY was denied the associated
expenses for effectuating the transaction. The Tax Court further found that the investment earnings derived by BNY
from the fund was a separate transaction from the loan piece in testing for *80 economic substance. As to the
source of the income, though the U.S.-U.K. treaty provided that income from assets held by a trust with a foreign trust
is foreign source income, it concluded the treaty was not applicable to transactions which lack economic substance.
The Court concluded that the income would be U.S. source income (ignoring the foreign taxes paid).
e. American International Group. Inc. v. United States, 111 AFTR2d 2013-1472 (DC NY, 2013). A subsidiary of AIG,
AIG Financial Products Corp. (AIG-FP), engaged in six transactions that were designed to be treated differently for U.S.
tax law and foreign law purposes. The transactions involved sale and repurchase agreements for preferred stock. AIG
treated the six transactions as loans. The IRS viewed the transactions as lacking economic substance and were entered
into solely to generate FTCs.
(1) Facts. In the prototype transaction, AIG-FP sold a foreign lender bank preferred stock in a foreign subsidiary.
However, AIG, as mentioned, treated the transactions as loans, while the IRS contended that the transaction were
entered into simply to generate FTCs. In each transaction, AIG-FP sold a foreign lender bank preferred shares in
a foreign affiliate of AIG-FP that was a special-purpose vehicle (SPV). AIG-FP was contractually committed to
repurchase the same shares after a term of years for the original amount paid. The SPV used its own capital to purchase
investments that generated a steady stream of income, and the SPV paid tax on that income to the relevant foreign
authorities. Little, if any, tax was imposed on the foreign lender as a result of the preferred shares being treated as
equity for foreign tax purposes.
For U.S. tax purposes as a loan, AIG reported the SPV's investment income but also treated the dividends paid by
the SPVs as deductible interest. AIG also claimed FTCs with respect to any foreign taxes paid by the SPVs. AIG
claimed that the transactions were merely highly profitable spread banking activity in which AIG used borrowed
money to generate cash returns.
(2) IRS Challenge. The IRS argued, however, that the transaction involved an attempt by both AIG and the foreign
lender to game the system in that the foreign lender did not pay tax on its dividend income and AIG was able to
claim FTCs and interest deductions with respect to the same items. The practical effect of this transaction was *81
that AIG was able to negotiate a lower dividend rate (effectively, interest rate) paid on the preferred stock because
it was able to provide tax benefits to the foreign lender.
As in the BNY case, the Service claimed that the transactions lacked economic substance, having no purpose,
substance, or utility apart from their tax consequences. AIG argued the transactions generated a pre-tax profit of over
$168M over the stated term and had had economic substance. The parties filed cross motions for partial summary
judgment. AIG argued that even though the transactions had economic substance, the economic substance doctrine
could not apply to the FTCs. The government countered that the FTC was enacted into law to provide for tax neutrality
and was not intended to address transactions that were structured so as to be subject to double taxation. The district court
agreed with the Service even though AIG's transaction technically complied with all of the requirements for FTCs.
(3) District Court Sides With United States. In invoking the economic substance doctrine, the court stated that tax
benefits will be disallowed if a transaction has no business purpose or economic effect other than the creation of
tax benefits. AIG argued that its after-tax consequences should be determined by starting with the SPV's investment
income, subtracting interest and operating expenses, and disregarding the foreign taxes paid by the SPV, the U.S.
income tax paid by AIG, and the value of the FTCs that AIG received. That is, AIG took all of its income and expenses
into account and concluded that it made a net profit, which meant that the transaction had economic substance. Sounds
good doesn't it? But, the district court analyzed there was one tax benefit that AIG did not address in its formulation
of the economic substance test, i.e. the tax benefit to the foreign lender. Here, the foreign lenders allowed the SPVs to
borrow at a below-market rate because of the tax benefits that the foreign lenders received. The government argued,
in essence, that the economic substance doctrine should be applied by assuming that all parties to the transaction were
fully taxable on their income, including the foreign lenders (who did not pay any U.S. tax in any event). Without the
lower interest rate charged by the foreign lenders, the SPVs would have made either no profit or a smaller profit, so
the IRS argued that the various tax benefits (foreign and domestic) were the *82 reasons that AIG entered into the
transaction, which reasons were not sufficient for economic substance purposes. The district court agreed with the
IRS and denied AIG's motion.
In AIG, the tax benefits to the foreign lenders were the central feature in producing a lower interest rate on the
loans. Since the transactions were designed to yield tax benefits to the foreign lender, such benefits had to be factored
into whether the transactions had economic substance aside from such tax benefits, even if it involved foreign taxes.
Without the benefit of reporting dividend income, the lenders would have increased AIG's borrowing rate which
would have reversed the profit into a loss. The FTCs were disallowed. It does not seem quite fair or appropriate to
apply the economic substance doctrine in this way. The tax benefits to the lender were in accordance with international
tax law norms. Why should such tax benefits to another party be part of the borrower's cost in projecting a profit
(aside from the tax benefits to it)? Seems like both BNY and AIG involved end result minded courts who got lost in
their own legal standards of properly applying the economic substance doctrine, either under common law, or under
7701(o). For a thoughtful review and criticism of both cases see a recent article by Richard Lipton, BNY and AIG--
Using Economic Substance to Attack Transactions The Courts Do Not Like, 119 TAX 40 (2013).
f. Pritired 1. LLC v. United States. 108 AFTR2d 2011-6605 (DC IA 2011).
(1) Facts. In the year 2000, Principal Financial Group and Citigroup formed a U.S. limited liability company, Pritired
1, LLC (Pritired 1), that in turn formed a wholly owned limited liability company, Pritired 2, LLC (Pritired 2 and,
together with Pritired 1, Pritired). Pritired entered into an agreement with two French banks, Natexis Bank and
Bred Banque Populaire (the French Banks), under which Pritired and the French banks formed a French limited
liability company (FrenchCo) that elected to be treated as a partnership for U.S. tax purposes. The capital structure
of FrenchCo included two classes of shares, a convertible note, and perpetual certificates. The Class A shares and the
convertible note were purchased by the French Banks for $930M. The Class B shares and the perpetual certificates
were purchased by Pritired for $300M FrenchCo used the *83 funds received from its owners to purchase commercial
securities from affiliates of the French Banks. Overall, these transactions resulted in a net transfer of $300M from the
United States to France.
When the arrangement was initially established or formed, the Class A shares had 98% of the voting rights and were
entitled to 99% of FrenchCo's profits after payments on the convertible note and the perpetual certificates. The Class
B shares had 2% of the voting rights and were entitled to 1% of distributable profits. After 12/31/05, the voting rights
of the Class A shares automatically fell to 50.1%, while the voting rights of the B shares automatically increased to
49.9%, and the holder of the B shares gained the unrestricted right to buy Class A shares sufficient to increase its
voting by 0.2%. After 12/31/05, therefore, Pritired had the unilateral right to liquidate FrenchCo. The terms of the
convertible note and the perpetual certificates were specified in detail by the operative documents. The relationship
between Pritired and the French Banks was set out in detail in the operating agreement of FrenchCo. Overall, under
these documents, Pritired expected to receive a pre-U.S.-tax return of LIBOR 2 plus 4.95% less French taxes. Interest
rates fell significantly after these transactions were put in place, and Pritired's LIBOR-based returns therefore declined.
However, interest rate floors that were part of the overall transactions meant that the reported income and reported
French income taxes of FrenchCo did not decline nearly as much as the return paid to Pritired.
For example, by 2002, because LIBOR had declined from 6.70% to approximately the range of 1.80% to 2.05%,
Pritired was not entitled to any distribution under the FrenchCo documents but FrenchCo nonetheless had substantial
earnings for French tax purposes and paid French income taxes of approximately $24M. The allocation of the French
taxes to Pritired allowed Pritired's partners to eliminate any U.S. taxes on their income from FrenchCo and, in addition,
to offset their U.S. taxes on other foreign source income. Taking into account these excess foreign tax credits, the
overall transactions generated an approximately 8% after-U.S.-tax return for the two U.S. partners.
The overall transaction had three important elements. First, French Co was a hybrid entity, i.e., it was treated as
a *84 corporation for French income tax purposes but as a partnership for U.S. income tax purposes. Second, the
convertible note was treated as controlling equity for French income tax purposes but as preferred equity carrying
limited but guaranteed payments--and thus very much like debt--for U.S. income tax purposes. Finally, the perpetual
certificates were treated as debt for French income tax purposes but as equity for U.S. income tax purposes.
The complex set of facts can be simplified as follows: two American companies sent $300M to two French banks
who combined the $300M with $900M of their own. The combined fund of $1.2B was used to earn income from low
risk financial instruments. French income taxes were paid on the income generated from the substantial investment.
The American companies received some cash from the income on the securities but, more importantly, were given
the ability to claim FTC paid on the entire 1.2 billion dollar pool. Through this transaction, the French banks were
able to borrow $300M at below market rates. In other words, the FTC generator effect allowed the U.S. lender to
instead enter into a joint venture with the French Bank and receive an allocation of all of the resulting FTCs. The
American companies received a very high return on an almost risk free investment. The parties executed the transaction
on October 27, 2000, and exited (unwound) it on December 31, 2005. As a result of the transaction, the U.S. partner
claimed approximately $21M in FTCs against its taxable income for the years 2002 and 2003.
(2) IRS Challenge; Refund Suit. The IRS alleges that the Pritired transaction was structured to accrue foreign tax
credits for its partners, but earned little to no cash return from its French investments. In the FPAA, i.e., the partnership
was subject to the TEFRA entity level audit rules, the IRS determined that Principal was not entitled to claim Pritired's
share of French foreign taxes paid or accrued for the years 2002 and 2003. Thus, the FTCs for the partners of Pritired,
including Principal were disallowed. The partnership disputed the FPPA adjustments to the partnership income and
filed this action to obtain a refund of the taxes resulting from the FPAA adjustments.
(3) Decision of District Court for Government. The U.S. District Court for the Southern District of Iowa is the
first *85 court to enter the fray. The gist of its thinking comes through clearly in the first paragraphs of the Pritired
opinion, when the court states:
Through this transaction, the French banks were able to borrow three hundred million dollars at below market
rates. The American companies received a very high return on an almost risk free investment. Only one thing could
make such a transaction so favorable to everyone involved. United States taxpayers made it work.
While the government presented the court with few arguments based on the actual Code and regulations, it was
successful in convincing the court that the foreign tax in question was generated by a foreign corporation that was not
a corporation, capitalized with equity that was not equity, and paying foreign income taxes on what was not income.
The Court found that the Class B shares and the perpetual certificates were in the nature of a loan and not equity, with
the result that Pritired was not a partner in FrenchCo and FrenchCo was not a partnership. The court relied on the
factors in Notice 94-47 and common law in evaluating the debt versus equity issue including: (i) characterization of
the documents by the parties; (ii) market risk, (iii) credit risk, and (iv) voting rights. The court found that the changing
voting rights and associated liquidation provisions resulted in the expectation of repayment of a sum certain on a finite
date of maturity, an entitlement in Pritired to ongoing payments during the term of the loan, with limited upside
or downside potential. The court also found that the transaction had no economic substance because the subjective
business purpose of the taxpayer was to enhance low-yield investments through the foreign tax credit and there was
no reasonable possibility of profit. Therefore, evidence of loan character included that transaction had ironclad
assurance there would always be tax credits built into tax return plus other indications that advances were made with
expectation of repayment and weren't placed at risk. Similarly, the Court found that there was no economic substance/
no real business purpose aside from generating FTCs when considering above plus facts that transaction built in
such things as interest rate floors that simply moved money around within French banks. Also, partnership was
otherwise disregardable, and FTCs were therefore, not allowable, pursuant to Treas. Reg 1.701-2's anti-abuse rule
since transaction didn't have *86 substantial business purpose; wasn't in substance equity investment as reported; and
improperly shifted FTCs to U.S. parties for no discernible reason, in contravention of Subchapter K purposes.
B. Treasury and Internal Revenue Service Respond to Passive Income Generator Problem. See discussion at page 29 and
related pages.
1. Final and Temporary Regulations to Section 901 On Foreign Tax Generators Amending, in Particular Treas. Reg.
1.902-2(e). T.D. 9535; 2011-39 IRB 415. On July 18, 2011, the Service and the Treasury published final, temporary and
proposed regulations under 901 with respect to foreign tax generator transactions. The temporary regulations generally
apply to payments that, if such payments were an amount of tax paid, would be considered paid or accrued on or after July
13, 2011. See discussion of the same topic above in Part of this Outline. A few of the highlights of the final regulations
are provided herein.
a. Treatment of Amounts Attributable to a Structured Passive Investment Arrangement. These final regulations
follow the 2008 Temporary Regulations to provide that amounts paid to a foreign taxing authority attributable to a
structured passive investment arrangement are not treated as an amount of tax paid for purposes of the foreign tax
credit. An arrangement that satisfies six conditions, as described in this preamble, is treated as a structured passive
investment arrangement. The final regulations do not, as some had suggested, differentiate between various investors
in structure passive investment arrangements based on their business practices and special circumstances surrounding
the arrangement.
b. The Special Purpose Vehicles Condition. Temp. Reg. 1.901-2(e)(5)(iv)(B)(l): The first condition in (2008) Temp.
Reg. 1.901-2T(e)(5)(iv)(B)(l) of the 2008 Temporary Regulations is that the arrangement utilizes an entity that meets
two requirements (the SPV condition).
(1) Substantially All Passive Investment Income. The first requirement is that substantially all of the entity's gross
income, as determined under U.S. tax principles, is attributable to passive investment income and substantially all of
the entity's assets are held to produce such passive investment income. Passive investment income is that defined in
954(c) with modifications. The final regulations provide that passive investment income does not include personal
service contract income per 954(c)(1)(H). Passive investment income generally includes the income of an upper-
tier entity attributable to *87 its equity interest in a lower-tier entity, but such income may be excluded from
passive investment income where it is attributable to a qualified equity interest in certain lower-tier entities that are
engaged in an active trade or business and other conditions apply (the holding company exception). See Treas.
Reg. 1.901-2T(e)(5)(iv)(c)(5)(ii). The final regulations clarify that income attributable to equity interests in pass-
through entities (including a partner's distributive share of partnership income and the income attributable to an entity
disregarded for U.S. tax purposes) is treated as passive investment income unless the holding company exception
applies.
(2) Income Attributable To Foreign Entity. The second of the two requirements of the SPV condition in the 2008
temporary regulations is that there is a foreign payment attributable to income of the entity. See Temp. Reg.
1.901-2T(e)(5)(iv)(B)(l)(ii). The foreign payment may be paid by the entity itself or by the owner(s) of the entity.
The 2007 proposed regulations and the 2008 temporary regulations both provide an exception that a foreign payment
does not include a withholding tax imposed on distributions or payments made by an entity to a U.S. party. However,
the IRS and the Treasury Department have become aware that taxpayers can enter into arrangements that generate
duplicative benefits involving foreign withholding taxes imposed on distributions made by an entity to a U.S. party.
For example, if the parties undertake a transaction in which interests in an SPV are transferred by the U.S. party to
a counterparty subject to a repurchase obligation, withholding taxes imposed on distributions from the SPV may be
claimed as creditable in both jurisdictions. Under the final regulations, the exception for withholding taxes imposed
on distributions or payments to U.S. parties is eliminated. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(l)(ii).
c. Revision to Holding Company Exception to Transactions Involving Multiple Counterparties or Multiple U.S. Parties.
The final regulations, in response to comments filed with the Service, clarify that where more than one U.S. party or more
than one counterparty or both are involved in the transaction, the requirement that the parties must share in substantially
all of the upper-tier entity's opportunity for gain and risk of loss with respect to its interest in a lower-tier entity is applied
by examining whether there is sufficient risk sharing by each of the groups comprising all U.S. parties (or person related
to such U.S. parties) and all *88 counterparties (or persons related to such counterparties). If there is more than one
U.S. party or more than one counterparty, the final regulations do not require that each member of the U.S. party and
counterparty groups share in the underlying investment risk. Finally, the holding company exception has been modified
to provide that where a U.S. party owns an interest in an entity indirectly through a chain of entities, the exception is
applied beginning with the lowest-tier entity in the chain before proceeding upward and the opportunity for gain and
risk of loss borne by any upper-tier entity in the chain that is a counterparty is disregarded to the extent borne indirectly
by a U.S. party.
(1) Definition of U.S. Party. See Treas. Reg. 1.901 - 2(e)(5)(iv)(B)(2): Section 1.901-2(e)(5)(iv)(B)(2) of the final
regulations adopts without change the second condition of the 2008 temporary regulations that a U.S. party is a person
who is eligible to claim a credit under 901(a), including a credit for taxes deemed paid under 902 or 960, for all
or a portion of the foreign payment if the foreign payment were an amount of tax paid (the U.S. party condition).
d. Required Direct Investment Condition. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(3). The Preamble to the Final
Regulations adopted in full the direct investment condition contained in the 2008 Temporary Regulations. The direct
investment condition requires that the U.S. party's share of the foreign payment or payments is (or is expected to be)
substantially greater than the amount of credits, if any, that the U.S. party reasonably would expect to be eligible to claim
under 901(a) for foreign taxes attributable to income generated by the U.S. party's proportionate share of the assets
owned by the SPV if the U.S. party directly owned such assets. While comments were noted to liberalize the Temporary
Regulations in this area, the Service and Treasury did not agree to ensure that the regulations cannot be avoided through
the use of foreign securities that produce income subject to withholding taxes, which both consider to be abusive.
e. Foreign Tax Benefit Condition. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(4). Treas. Reg. 1.901-2(e)(5)(iv)(B)(4) of
the final regulations adopts with minor changes the fourth condition of the 2008 Temporary Regulations (the foreign tax
benefit condition). The foreign tax benefit condition requires that the arrangement is reasonably expected to result in a
tax benefit to a counterparty (or a related person) under the laws of a foreign country. If the foreign tax benefit available
to the counterparty is a credit, then such credit must correspond to 10% or more of the U.S. party's share (for U.S. *89
tax purposes) of the foreign payment. Other types of foreign tax benefits, such as exemptions, deductions, exclusions
or losses, must correspond to 10% percent or more of the foreign base with respect to which the U.S. party's share (for
U.S. tax purposes) of the foreign payment is imposed. As noted in the Preamble The 10% correspondence requirement
is designed to limit any potential disallowance of foreign tax credits to cases in which there is a material duplication
of the tax benefits. The Final Regulations retain this requirement. The related party rules were also retained from the
Temporary Regulations. The IRS and the Treasury Department concluded that it was necessary to include related parties
because of the variety of duplication techniques otherwise available to taxpayers, including the use of benefits arising to
members of a related group of entities, and accordingly the comment was not adopted. Under the Final Regulations the
10% correspondence requirement compares the aggregate amount of foreign tax benefits available to all counterparties
and persons related to such counterparties to the aggregate amount of the U.S. parties' share of the foreign payment or
the foreign base, as the case may be.
f. Counterparty Condition. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(5). The fifth condition provided in Temp. Reg.
1.901-2T(e)(5)-(iv)(B)(5) is that the arrangement include a person that, under the tax laws of a foreign country in
which the person is subject to tax on the basis of place of management, place of incorporation or similar criterion or
otherwise subject to a net basis tax, directly or indirectly owns or acquires equity interests in, or assets of, the SPV
(the counterparty condition). The 2008 Temporary Regulations provided a related party prohibition, i.e., a permitted
counterparty does not include the SPV or a person with respect to which the same domestic corporation, U.S. citizen or
resident alien individual directly or indirectly owns more than 80% of the total value of the stock (or equity interests) of
each of the U.S. party and such person. Also, a permitted counterparty does not include a person with respect to which
the U.S. party directly or indirectly owns more than 80% of the total value of the stock (or equity interests), but only if the
U.S. party is a domestic corporation, a U.S. citizen or a resident alien individual. In response to submitted comments that
the breadth of the counterparty condition could result in treating as a counterparty an upper-tier entity in which a U.S.
investor and a foreign investor each hold interests, and that to the extent that the foreign tax benefits resulting from such
structures are not duplicative, the Final Regulations revise the foreign tax benefit condition to provide that certain tax
benefits claimed by upper-tier entities do not correspond to the U.S. party's share of the foreign payment. Specifically,
where a U.S. party *90 indirectly owns a non-hybrid equity interest in an SPV, a foreign tax benefit available to a
foreign entity in the chain of ownership which begins with the SPV and ends with the first-tier entity in such chain does
not correspond to the U.S. party's share of the foreign payment attributable to the SPV to the extent that such benefit
relates to earnings of the SPV that are distributed with respect to non-hybrid equity interests in the SPV that are owned
indirectly by the U.S. party for purposes of both U.S. and foreign tax law. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(4). The
Preamble to the Final Regulations states that the revision is intended to ensure that the foreign tax benefit condition is
not satisfied in cases where the U.S. and foreign investors claim only those tax benefits that are consistent with their
respective investments in the arrangement and their interests are treated as equity and owned by the same persons in
both jurisdictions.
g. Dual Citizens or U.S. Residents. The Final Regulations, again in response to comments, have modified the Final
Regulations to provide that individuals or are subject to U.S. tax on their worldwide income should not be treated as
counterparties since any reduction in foreign tax liability will result in a corresponding increase in U.S. taxes owed.
h. Family Members. While the Service and Treasury received comments that individuals who are members of the
same family of a U.S. party should not be treated as counterparties, the idea was flatly reject as noted in the Preamble. It
explained again that the exception from the counterparty condition for certain U.S.-controlled foreign counterparties is
based on the premise that the foreign tax benefit available to such a counterparty confers only a timing benefit that will
reverse itself when the counterparty repatriates its earnings to the United States. The regulations, both the 2007 Proposed
Regulations and the 2008 Temporary Regulations were not focused on timing differences. That is why the earlier drafts
of the regulations excluded certain foreign persons owned by the U.S. party or by certain United States persons who also
own the U.S. party. In contrast, where an individual is related to a U.S. party but is not a United States person for U.S.
tax purposes, the reduction in foreign tax liability obtained by such individual does not result in a corresponding increase
in U.S. tax. Accordingly, the Final Regulations do not include an exclusion for such individuals.
i. Compensation Stock. A comment to the regulations project suggested that the receipt of 83 stock by a service
provider should not be treated along with his employer as counterparties. This suggestion, as noted in the Preamble, was
rejected on the basis that *91 regardless of the means by which a person acquires its interest in an SPV, the presence of
a duplicative tax benefit is no less problematic because its recipient acquired its interest in an SPV in return for services
instead of capital.
j. Application To Non-Related U.S. Party. Finally another comment noted in the Preamble to the Final Regulations
recommended that where one U.S. party owns more than 80% of a counterparty but another U.S. does not, the final
regulations should treat a foreign payment as noncompulsory only to the extent of the unrelated U.S. party's share of the
foreign payment. This comment was not adopted. These regulations are intended to disallow foreign tax credits claimed
in connection with structured passive investment arrangements. The tax policy concerns on disallowing the use of tax
abusive structures remain the same regardless of whether the arrangement satisfies the six conditions of the regulations
with respect to one U.S. party or multiple U.S. parties.
k. Inconsistent Treatment Condition. See Treas. Reg. 1.901-2(e)(5)(iv)(B)(6). The inconsistent treatment condition
requires that the United States and an applicable foreign country treat the arrangement inconsistently under their
respective tax systems and that the U.S. treatment results in either materially less income or a materially greater amount
of foreign tax credits than would be available if the foreign law controlled the U.S. tax treatment. This condition is
intended to limit the disallowance of credits to those arrangements that exploit inconsistencies in U.S. and foreign law
to secure a foreign tax credit benefit.
VII. FOREIGN TAX SPLITTER PROVISIONS. EDUCATION JOBS AND MEDICAID ASSISTANCE ACT OF
2010 (P.L. 111-226); FINAL REGULATIONS TO THE TAX SPLITTER PROVISIONS AND THE TECHNICAL
TAXPAYER RULES.
A. Overview of Section 909.
Of the several provisions pertaining to international taxation contained in EJMAA, most noteworthy is the new rule which
requires a matching of foreign tax credits with the related foreign source income which is contained in new 909. The
Treasury had lobbied for this type of provision given the government's loss in Guardian Industries Corp. v. United States,
65 Fed. Cl. 50 (Ct. Fed. Cl. 2005), aff'd, 477 F.3d 1368 (Fed. Cir. 2007). In Guardian Industries, supra, the IRS failed in
its effort to deny the FTC to a US multinational on account of taxes paid by affiliates of a Luxembourg subsidiary that had
elected to be treated as a disregarded entity under the check-the-box rules. In response to its loss in Guardian Industries,
the Service issued proposed regulations denying technical *92 taxpayer status to a company that did not actually pay the
foreign tax sought to be credited (REG 124152-06, 8/4/06).
Section 909 was enacted to suspend claiming the FTC where the associated foreign tax and the income to which it relates
are separated (in a so-called splitter transaction). See also Prop. Reg. 1.901-2(f). The proposed regulations provided that,
in general, the person entitled to claim a credit for foreign taxes is the person who owns (under foreign tax law) the income
that is subject to the foreign tax, i.e., the matching concept. The rationale for having a matching rule for foreign tax credits
is that double taxation on foreign source income is ameliorated only where the person generating the foreign course income
is the same person who is allowed to claim the credit for the taxes paid or accrued.
Section 909 provides that there is a foreign tax credit splitting event if a foreign income tax is paid or accrued by a taxpayer
or 902 corporation and the related income is, or will be, taken into account by a covered person with respect to such taxpayer
or 902 corporation. In such a case, the tax is suspended until the taxable year in which the related income is taken into
account by the payor of the tax or, if the payor is a 902 corporation, by a 902 shareholder of the 902 corporation.
On December 6, 2010, the Treasury Department and the IRS issued Notice 2010-92 (2010-2 CB 916 (December 6, 2010)),
which primarily addresses the application of section 909 to foreign income taxes paid or accrued by a section 902 corporation
in taxable years beginning on or before December 31, 2010 (pre-2011 taxable years). The notice provides rules for determining
whether foreign income taxes paid or accrued by a section 902 corporation in pre-2011 taxable years (pre-2011 taxes) are
suspended under section 909 in taxable years beginning after December 31, 2010 (post-2010 taxable years) of a section 902
corporation. It also identifies an exclusive list of arrangements that will be treated as giving rise to foreign tax credit splitting
events in pre-2011 taxable years (pre-2011 splitter arrangements) and provides guidance on determining the amount of related
income and pre-2011 taxes paid or accrued with respect to pre-2011 splitter arrangements. The pre-2011 splitter arrangements
are reverse hybrid structures, certain foreign consolidated groups, disregarded debt structures in the context of group relief
and other loss-sharing regimes, and two classes of hybrid instruments. The notice states that future guidance will provide that
foreign tax credit splitting events in post-2010 taxable years will at least include all of the pre-2011 splitter arrangements.
The notice also states that the Treasury Department and the IRS do not intend to finalize the portion of the 2006 proposed
regulations relating to the determination of the person who paid a foreign income tax with respect to the income of a reverse
hybrid. See Prop. 1.901-2(f)(2)(iii
B. Proposed Regulations To the Technical Taxpayer Rules Issued by Service in 2006 After Its Loss in Guardian Industries,
supra.
Treasury and the IRS issued Proposed Regulations to change who the technical taxpayer is for foreign consolidated groups
and for reverse hybrids, hybrid *93 entities, and foreign defective entities. (REG-124152-06, 8/3/06). See Treas. Reg.
1.901-2(f)(l).
1. Who Is the Technical Taxpayer? The 2006 Proposed Regulations held that foreign law is considered to impose legal
liability on the person required to take such income into account for foreign income tax purposes regardless of who is
required to remit the tax. See Prop. Reg. 1.901-2(f)(2)(i)(treats as irrelevant which person is obligated to remit the tax,
which person actually remits the tax, or which person the foreign country could proceed against to collect the tax....).
2. Foreign Consolidated Groups: Reversing the Guardian Result. The 2006 Proposed Regulations, however, addressed
foreign consolidations (such as that in Guardian) by allocating foreign taxes paid or accrued by a parent to each person in the
group in proportion to its portion of the combined income of the group. Applied to the facts in Guardian, the Luxembourg
parent corporation (defective entity) would be allocated foreign taxes only on its actual income and not the fiscal unity
group's income.
3. Treatment of Hybrid Entities. The 2006 Proposed Regulations treated reverse hybrids (corporation for U.S. tax law
purposes, and pass through or defective entity for foreign tax purposes) by allocating to them a proportionate share of foreign
taxes even though the income of a reverse hybrid flows through to its owner for foreign tax purposes. As to regular hybrid
entities, the 2006 Proposed Regulations provided that if a foreign company is a defective entity for U.S. tax purposes the
deemed owner of the assets is considered to be the technical taxpayer. Prop. Reg. 1.901-2(f)(3)(ii). In a hybrid partnership
(i.e., an entity treated as a corporation for foreign tax purposes but a partnership for U.S. purposes), the partnership is the
technical taxpayer of taxes paid by the entity, and the tax is allocated to the partners under Section 704(b). Prop. Reg.
1.901-2(f)(3)(i). The 2006 Proposed Regulations did not address splitter arrangements from hybrid instruments.
4. Final and Temporary Regulations to Legal Liability Rule in Treas. Reg. 1.901-2(f)(4). See discussion above
beginning at page 36.
5. Yielded to Section 909. The 2006 Proposed Regulations would later yield its status in 901 to 909. The expansiveness
of the concepts and rules in the 2006 Proposed Regulations would narrow somewhat in the regulations under 909.
C. Committee Report Explanation on Section 909. Joint Committee on Taxation Report [JCX-46-10].
1. In General. The provision adopts a matching rule to prevent the separation of creditable foreign taxes from the
associated foreign income. *94 In general, the provision states that when there is a foreign tax credit splitting event with
respect to a foreign income tax paid or accrued by the taxpayer, the foreign income tax is not taken into account for Federal
tax purposes before the taxable year in which the related income is taken into account by the taxpayer under chapter 1 of
the Code. In addition, if there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued
by a section 902 corporation, that tax is not taken into account for purposes of section 902 or 960, or for purposes of
determining earnings and profits under section 964(a), before the taxable year in which the related income is taken into
account for Federal income tax purposes by the section 902 corporation, or a domestic corporation that meets the ownership
requirements of 902(a) or (b) with respect to the section 902 corporation. Thus, such tax is not added to the section 902
corporation's foreign tax pool, and its earnings and profits are not reduced by such tax.
2. Section 909 Applies At Partner, S Corp. Shareholder or Beneficiary Level. In the case of a partnership, the provision's
matching rule is applied at the partner level, and, except as otherwise provided by the Secretary, a similar rule applies in the
case of any S corporation or trust. The Secretary may also issue regulations to establish the applicability of this matching
rule to a regulated investment company that elects under section 853 for the foreign income taxes it pays to be treated as
creditable to its shareholders under section 901.
3. The Trigger: A Foreign Tax Credit Splitting Event. [T]here is a foreign tax credit splitting event with respect to
a foreign income tax if the related income is (or will be) taken into account for Federal income tax purposes by a covered
person. (footnote text omitted). .... Related income means, with respect to any portion of any foreign income tax, the
income (or, as appropriate, earnings and profits), calculated under U.S. tax principles, to which such portion of foreign
income tax relates. For purposes of determining related income, the Secretary may provide rules on the treatment of losses,
deficits in earnings and profits, and certain timing differences between U.S. and foreign tax law. Moreover, it is not intended
that differences in the timing of when income is taken into account for U.S. and foreign tax purposes (e.g., as a result of
differences in the U.S. and foreign tax accounting rules) should create a foreign tax credit splitting event in cases in which
the same person pays the foreign tax and takes into account the related income, but in different taxable periods.
4. Concept of a Covered Person. With respect to any person who pays or accrues a foreign income tax... (payor), a
covered person is: (1) any entity in which the payor holds, directly or indirectly, at least a 10-percent ownership interest
(determined by vote or value); (2) any person that holds, directly or indirectly, at least a 10-percent ownership interest
(determined by vote or value) in the payor; (3) any person that bears a *95 relationship to the payor described in section
267(b) or 707(b) (including by application of the constructive ownership rules of section 267(c)); and (4) any other person
specified by the Secretary. Accordingly, the Secretary may issue regulations that treat an unrelated counterparty as a covered
person in certain sale-repurchase transactions and certain other transactions deemed abusive.
5. Suspension of FTCs Not Currently Taken Into Account Due to Matching Rule in Section 909. Except as otherwise
provided by the Secretary, in the case of any foreign income tax not currently taken into account by reason of the provision's
matching rule, such tax is taken into account as a foreign income tax paid or accrued in the taxable year in which, and to the
extent that, the taxpayer, the section 902 corporation, or a domestic corporation that meets the ownership requirements of
section 902(a) or (b) with respect to the section 902 corporation (as the case may be) takes the related income into account
under chapter 1 of the Code. Accordingly, for purposes of determining the carryback and carryover of excess foreign tax
credits under section 904(c), the deduction for foreign taxes paid or accrued under section 164(a), and the extended period
for claim of a credit or refund under section 6511(d)(3)(A), foreign income taxes to which the provision applies are first
taken into account, and treated as paid or accrued, in the year in which the related foreign income is taken into account.
Notwithstanding the preceding rule, foreign taxes are translated into U.S. dollars in the year in which the taxes are paid or
accrued under the general rules of section 986 rather than the year in which the related income is taken into account. The
Secretary may issue regulations or other guidance providing additional exceptions.
6. Authority to Issue Legislative Regulations, Other Guidance. The Secretary is also granted authority to issue
regulations or other guidance as is necessary or appropriate to carry out the purposes of the provision. Such guidance may
include providing successor rules addressing circumstances such as where, with respect to a foreign tax credit splitting
event, the person who pays or accrues the foreign income tax or any covered person is liquidated. This grant of authority
also allows the Secretary to provide appropriate exceptions from the application of the provision as well as to provide
guidance as to how the provision applies in the case of any foreign tax credit splitting event involving a hybrid instrument.
It is anticipated that the Secretary may also provide guidance as to the proper application of the provision in cases involving
disregarded payments, group relief or other arrangements having a similar effect.
7. Example of FTC Splitter. An example of a foreign tax credit splitting event involving a hybrid instrument subject
to the provision is as follows. U.S. Corp., a domestic corporation, wholly owns CFC1, a country A corporation. CFC1, in
turn, wholly owns CFC2, a country A corporation. CFC2 is engaged in an active business that generates $100 of income.
*96 CFC2 issues a hybrid instrument to CFC1. This instrument is treated as equity for U.S. tax purposes but as debt
for foreign tax purposes. Under the terms of the hybrid instrument, CFC2 accrues (but does not pay currently) interest to
CFC1 equal to $100. As a result, CFC2 has no income for country A tax purposes, while CFC1 has $100 of income, which
is subject to country A tax at a 30 percent rate. For U.S. tax purposes, CFC2 still has $100 of earnings and profits (the
accrued interest is ignored since the United States views the hybrid instrument as equity), while CFC1 has paid $30 of
foreign taxes. Under the provision, the related income with respect to the $30 of foreign taxes paid by CFC1 is the $100
of earnings and profits of CFC2.
8. Effective Date of Section 909. In general, the provision is effective with respect to foreign income taxes paid or
accrued by U.S. taxpayers and section 902 corporations in taxable years beginning after December 31, 2010. The provision
also applies to foreign income taxes paid or accrued by a section 902 corporation in taxable years beginning on or before
December 31, 2010 (and not deemed paid under section 902(a) or 960 on or before such date), but only for purposes of
applying sections 902 and 960 with respect to periods after such date (the deemed-paid transition rule). Accordingly, the
deemed-paid transition rule applies for purposes of applying 902 and 960 to dividends paid, and inclusions under section
951(a) that occur, in taxable years beginning after December 31, 2010. However, no adjustment is made to a section 902
corporation's earnings and profits for the amount of any foreign income taxes suspended under the deemed-paid transition
rule, either at the time of suspension or when such taxes are subsequently taken into account under the provision.
D. General Principles of Section 909 And Related Guidance.
1. Strict Matching Approach Adopted in Section 909. A strict matching approach is compromised where there is a so-
called splitter transaction when the income (or earnings or profits under 902 or 960 credit provisions) allocable to the
foreign taxes is taken into account by a U.S. person related to the payor of the foreign taxes or by another person. The foreign
source income goes to one taxpayer and the foreign taxes (and credits) are paid by a related taxpayer, i.e., the covered
person. A covered person is a person who directly or indirectly owns at least 10% of vote or value, or a person related to
the taxpayer within 267(b), 707(b) or any person specified by the regulations. New 909(a) provides that if there is a
foreign tax credit splitting event with respect to a foreign income tax paid or accrued by the taxpayer, such tax (credit) shall
not be taken into account for purposes of this title before the taxable year in which the related income is taken into account
under this chapter by the taxpayer. The new anti-splitting (or matching) rule of 909 attempts to give the FTC (in the
case of a splitter transaction) to the person who takes the related income into account for U.S. tax purposes, not foreign tax
purposes. For *97 purposes of a 902 or 960 foreign tax credit, such credits are not taken into account until the related
income is taken into account by the same corporation that paid or accrued the taxes. For partnerships, 909 is applied at the
partner level. If the requirements of 909(a) are not met, the underlying FTC is not allowable until the year in which the
related income is taken into account. 909(c)(2). Deferred foreign taxes do not affect 904(c) carryovers, 6511(d)(3)(A)
extended periods for claiming a credit or refund, or for other purposes until 909(a)'s requirements are made. Moreover,
the deferred foreign taxes cannot be deducted before such year. See also 986(a). Other calculations under the code until
the year in which they are taken into account under section 909, nor can they be claimed as deductions before that year.
2. Foreign Tax Splitting Event. When it is found to occur, the tax is suspended for FTC or deduction purposes until the
taxpayer recognizes the related income. 909(a). A foreign tax credit splitting event occurs if the foreign tax is taken into
account for U.S. income tax purposes by a covered person rather than by the taxpayer (i.e., the suspension does not
arise merely because of timing differences between the foreign and U.S. law). 904(d)(l).
3. Covered Persons. A covered person, described under 909(d)(4),is any of the following: (i) an entity in which the
payor holds (directly or indirectly) at least a 10% ownership interest (by vote or value); (ii) a person who holds (directly
or indirectly) such an interest (by vote or value) in the payor; (iii) a person identified in 267(b) or 707(b); or (iv)any
person specified by the Secretary.
4. Related Income. Income or the earnings and profits (E&P) to which a given portion of the foreign tax relates. 909(d)
(3). The identification of related income and split taxes is controlled by an interim rule under which the principles of Treas.
Regs. 1.909-6T(d)-(f)(foreign income taxes paid or accrued in post-2010 taxable years). See Notice 2012-92, 2010-52
I.R.B. (otherwise applicable to pre-2011 taxable years). Treas. Reg. 1.909-6T(d)(4)(adopts the related income first out
method of identifying related income, but is not applicable to post-2010 taxable years).
5. Indirect Foreign Tax Credits and Section 909. Under 909(b) where a splitting event arose with respect to taxes paid or
accrued by a 902 corporation, the split tax would not be taken into account for purposes of 902, 960 or 964(a) prior to
the taxable year in which the related income is taken into account by the 902 corporation itself or one of its shareholders.
Therefore, the split taxes paid or accrued by a 902 corporation become suspended at the payor level.
*98 6. FTC Splitter Rules and Partnerships, S Corporations and Trusts. With respect to flow-thru entities, 909 is
operative at the partner, shareholder or beneficiary level. 909(c)(l).
7. Notice 2010-92, 2010-52 I.R.B. 916. Announced, as interim guidance under 909, an exclusive list of arrangements
that are FTC splitting events for applying 909 to pre-2011 taxes and provides guidance on identifying the pre-2011 split
taxes and related income with respect to each such arrangement.
a. Reverse Hybrid Structures Involving Section 902 Corporation. A reverse hybrid is an entity that is a corporation for
U.S. federal income tax purposes but is a pass-through entity or a branch under the laws of a foreign country imposing
tax on the income of the entity. As a result, the owner of the reverse hybrid is subject to tax on the income of the entity
under foreign law. A pre-2011 splitter arrangement involving a reverse hybrid structure exists when pre201 1 taxes are
paid or accrued by a 902 corporation on income of a reverse hybrid that is a covered person as to the 902 corporation.
A pre-2011 splitter arrangement involving a reverse hybrid structure may exist even if the reverse hybrid has a deficit
in earnings and profits for a particular year. Such taxes paid or accrued by the 902 corporation are pre-2011 split taxes.
The related income is the earnings and profits (computed for U.S. federal income tax purposes) of the reverse hybrid
attributable to the activities of the reverse hybrid that gave rise to income included in the foreign tax base with respect to
which the pre-2011 split taxes were paid or accrued. Accordingly, related income of the reverse hybrid would not include
any item of income or expense attributable to a disregarded entity (as defined in 301.7701-2(c)(2)(i)) owned by the
reverse hybrid if income attributable to the activities of the disregarded entity is not included in the foreign tax base.
b. Certain Foreign Consolidated Groups As a Pre-2011 Splitter Arrangement. A foreign consolidated group is a
pre-2011 splitter arrangement to the extent that the taxpayer did not allocate the foreign consolidated tax liability among
the members of the foreign consolidated group based on each member's share of the consolidated taxable income
included in the foreign tax base under the principles of 1.901-2(f)(3). A pre-2011 splitter arrangement involving a
foreign consolidated group may exist even if one or more members has a deficit in earnings and profits for a particular
year (for example, due to a timing difference). Pre-2011 taxes paid or accrued with respect to the income of a foreign
consolidated group are pre-2011 split taxes to the extent that taxes paid or accrued by one member of the foreign
consolidated group are *99 imposed on a covered person's share of the consolidated taxable income included in the
foreign tax base. The related income is the earnings and profits (computed for U.S. federal income tax purposes) of such
other member attributable to the activities of that other member that gave rise to income included in the foreign tax base
with respect to which the pre-2011 split taxes were paid or accrued.
c. Group Relief and Other Loss-Sharing Regimes. A pre-2011 splitter arrangement involving a shared loss exists when
the following three conditions are met:
(a) an instrument is treated as bona fide debt under the laws of the jurisdiction in which the issuer is subject to tax
and that is disregarded for U.S. federal income tax purposes (a) disregarded debt instrument), i.e., (a) a debt between
two defective entities owned by the same 902 corporation; (b)a debt between two defectives owned by a partnership
with one or more partners that are 902 corporations; (c) a 902 corporation and a disregarded entity owned by that
902 corporation; or (d) a partnership in which the 902 corporation is a partner and a disregarded entity that is owned
by such partnership;
(b) the owner of the disregarded debt instrument pays a foreign income tax attributable to a payment or accrual on
the instrument; and
(c) the payment or accrual on the disregarded debt instrument gives rise to a deduction for foreign tax purposes and
the issuer of the instrument incurs a shared loss that is taken into account under foreign law by one or more entities
that are covered persons with respect to the owner of the instrument.
d. Hybrid Instruments. Hybrid instruments, which exist where an instrument is treated as either debt or equity for U.S.
tax purposes and as the other for foreign tax purposes were also identified as potential FTC splitting events in the Notice.
Notice 2010-92 also stated that the Treasury and the Service expected that future guidance will provide that foreign
tax credit splitting events in post-2010 taxable years will at least include all of the arrangements identified in this Notice
and may also provide that Section 909 also applies to other transactions or arrangements not so identified but only
with respect to foreign income taxes *100 paid or accrued in post-2010 taxable years.. See Notice 2010-92, 4.01,
2010-2 CB at 918-919.
Note: Section 909 is effective for foreign taxes paid or accrued in tax years beginning after 2010 (post-2010 taxes).
Section 909 does not apply to foreign taxes that have been paid or deemed paid by a U.S. person before 2011. Still 909
also applies to taxes paid or accrued during tax years beginning before 2011 (pre-2011 taxes) if they (1) remained
in the post-1986 foreign tax credit pools of a 902 corporation, and (2) were paid pursuant to certain pre-2011 splitter
arrangements. The beginning post-1986 tax pool for the first post-2010 tax year must be divided between split taxes that
are suspended and other taxes that may be used by the U.S. shareholder.
8. Final Regulations Issued under Section 901 (TD 9576, 2/8/12). Provide guidance on who is considered the technical
taxpayer of foreign taxes under a new test. Notice 2007-95, 2007-2 CB 1091 is obsolete as of 2/14/2012. The final
regulations to 901 adopted 1.901-2(f)(2)(ii) of the 2006 Proposed Regulations with several modifications.
a. Combined Basis Reporting of FTCs. Treas. Reg. 1.901-2(f)(3)(ii) provides that tax is considered to be computed
on a combined basis if two or more persons that would otherwise be subject to foreign tax on their separate taxable
incomes add their items of income, gain, deduction, and loss to compute a single consolidated taxable income amount
for foreign tax purposes.
b. Fiscally Transparent Entity. A foreign tax is not considered to be imposed on the combined income of two or more
persons if, because one or more of such persons is a fiscally transparent entity under foreign law, only one of such persons
is subject to tax under foreign law (even if two or more of such persons are corporations for U.S. tax purposes). The
Final Regulations clarify that foreign tax is not considered to be imposed on combined income solely because foreign
law: (1) reallocates income from one person to a related person under foreign transfer pricing provisions; (2) requires
a person to take into account a distributive share of taxable income of an entity that is a partnership or other fiscally
transparent entity for foreign tax law purposes; or (3) requires a person to take all or part of the income of an entity that
is a corporation for U.S. tax purposes into account because foreign law treats the entity as a branch or fiscally transparent
entity (a reverse hybrid). A reverse hybrid does not include an entity that is treated under foreign law as a branch or
fiscally transparent entity solely for purposes of calculating combined income of a foreign consolidated group.
*101 c. Reverse Hybrid Entity. Treas. Reg. 1.901-2(f)(2)(iii) of the 2006 Proposed Regulations provides that a
reverse hybrid is considered to have legal liability under foreign law for foreign taxes imposed on the owners of the
reverse hybrid in respect of each owner's share of the reverse hybrid's income. As stated in Notice 2010-92, the Treasury
Department and the IRS will not finalize the portion of the 2006 proposed regulations relating to the determination of the
person who paid a foreign income tax with respect to the income of a reverse hybrid. Notice 2010-92 identifies reverse
hybrids as pre-2011 splitter arrangements, and the temporary regulations under section 909 also identify reverse hybrids
as splitter arrangements.
d. Share of Combined (Foreign Tax) Income Base.
(1) 2006 Proposed Regulations. Prop. Treas. Reg. 1.901-2(f)(2)(iv) of the 2006 Proposed Regulations provided
rules for determining each person's share of the combined income tax base, generally relying on foreign tax reporting
of separate taxable income or books maintained for that purpose. The 2006 proposed regulations provide that payments
between group members that result in a deduction under both U.S. and foreign tax law will be given effect in
determining each person's share of the combined income. The 2006 proposed regulations, however, explicitly reserve
with respect to the effect of hybrid instruments and disregarded payments between related parties, which the preamble
to the proposed regulations describes as a matter to be addressed in subsequent published guidance. Section 1.901-2(f)
(2)(iv) of the 2006 proposed regulations also provides special rules addressing the effect of dividends (and deemed
dividends) and net losses of group members on the determination of separate taxable income.
(2) Final Regulations to Section 901 (2012). Treas. Reg. 1.901-2(f)(3)(iii) adopts Prop Reg. 1.901-2(f)(2)(iv)
with modifications reflecting that certain hybrid instruments and certain disregarded payments are treated as splitter
arrangements subject to 909. The Final Regulations provide that in determining separate taxable income of members
of a combined income group, effect will be given to intercompany payments that are deductible under foreign law,
even if such payments are not deductible (or are disregarded) for purposes of U.S. tax law. Thus, for example, interest
accrued by one group member with respect to an instrument held by another member that is *102 treated as debt
for foreign tax purposes but as equity for U.S. tax purposes would be considered income of the holder and would
reduce the taxable income of the issuer. The Final Regulations, however, include a cross-reference to Treas. Reg.
1.909-2T(b)(3)(i) for rules requiring suspension of foreign income taxes paid or accrued by the owner of a U.S. equity
hybrid instrument.
e. Payment By Related Party of Another Person's Foreign Tax.
(1) Proposed Regulations (2006) Treatment. Prop. Reg. 1.901-2(f)(2)(v) provided that U.S. tax principles apply to
determine the tax consequences if one person remits a tax that is the legal liability of another person. For example, a
payment of tax for which a corporation has legal liability by a shareholder of that corporation (including an owner of a
reverse hybrid), will ordinarily result in a deemed capital contribution and deemed payment of tax by the corporation.
(2) Final Regulations to Section 901 (2012). The Final Regulations provide that U.S. tax principles apply to
determine the tax consequences if one person remits a tax that is the legal liability of another person, i.e., in determining
who is the technical taxpayer.
f. Foreign Taxes Imposed On Partnerships and Disregarded Entities.
(1) Proposed Regulations (2006). Prop. Reg. 1.901-2(f)(3) set forth rules regarding the treatment of two types
of hybrid entities. First, an entity that is treated as a partnership for U.S. income tax purposes but is taxable at the
entity level under foreign law (a hybrid partnership), such entity is considered to have legal liability under foreign law
for foreign income tax imposed on the income of the entity. The 2006 Proposed Regulations also provide rules for
allocating foreign tax paid or accrued by a hybrid partnership if the partnership's U.S. taxable year closes with respect
to one or more (or all) partners or if there is a change in ownership of the hybrid partnership. See Prop. Reg.1.901-2(f)
(3)(i).
Second, as to a defective entity, the person that is treated as owning the assets of such entity for U.S. tax purposes
is considered to have legal liability under foreign law for tax imposed on the income of the entity. The 2006 Proposed
Regulations provide rules for allocating foreign tax *103 between the old owner and the new owner of a disregarded
entity if there is a change in the ownership of the disregarded entity during the entity's foreign taxable year and such
change does not result in a closing of the entity's foreign taxable year. See Prop Reg. 1.901-2(f)(3)(ii). The 2006
Proposed Regulations generally provide that for hybrid partnerships and disregarded entities, allocations of tax will be
made under the principles of Treas. Reg. 1.1502-76(b) based on the respective portions of the taxable income of the
hybrid entity (as determined under foreign law) for the foreign taxable year that are attributable to the period ending
on the date of the ownership change (or the last day of the terminating partnership's U.S. taxable year) and the period
ending after such date. This is consistent with Treas. Reg. in 1.338-9(d) for apportioning foreign tax paid by a target
corporation that is acquired in a transaction that is treated as an asset acquisition pursuant to an election under 338,
if the foreign taxable year of the target does not close at the end of the acquisition date.
Third, a change in the ownership of a hybrid partnership or disregarded entity during the entity's foreign taxable
year that does not result in the closing of the hybrid entity's foreign taxable year may result in the separation of income
from the associated foreign income taxes. A change in the ownership occurs if there is a disposition of all or a portion
of the owner's interest. A separation of income from the associated foreign income taxes could occur if the foreign tax
paid or accrued with respect to such foreign taxable year has not been allocated appropriately between the old owner
and the new owner. Certain changes of ownership involving related parties could be treated as a FTC splitting event
under 909. The regulations are also discussed below.
(2) Final Regulations (2012). The Final Regulations adopt the Proposed Regulations (2006) with certain
modifications in response to comments. The Final Regulations apply the same foreign tax allocation rules to 708
terminations that arise under 708(b)(l)(A) in the case of a partnership that has ceased its operations, including a
change in ownership in which a partnership becomes a disregarded entity. The Final Regulations to 901 also apply
the same allocation rules if there are multiple ownership changes within a single foreign taxable year. The 2006
Proposed Regulations would generally apply to foreign taxes paid or accrued *104 during taxable years beginning on
or after January 1, 2007. However, consistent with Notice 2007-95, Treas. Reg. 1.901-2(h)(4) provides that the Final
Regulations are generally effective for foreign taxes paid or accrued in taxable years beginning after February 14, 2012.
9. Temporary Regulations Issued in 2012 Under Section 909. The Temporary Regulations to 909 set forth an exclusive
list of arrangements that will be treated as giving rise to FTC splitting events regarding foreign income taxes paid or accrued
in tax years beginning after December 31, 2011. The Temporary Regulations also provide that foreign income taxes paid
or accrued by any person in a tax year beginning in 2011, in connection with a pre-2011 splitter arrangement, are split
taxes to the same extent that they would have been treated as pre-2011 split taxes if they were paid or accrued by a section
902 corporation in a pre-2011 tax year.
a. Splitter Events Identified. The transactions or arrangements identified in the Temporary Regulations include reverse
hybrid splitter arrangements and hybrid instrument splitter arrangements, the definitions of which are substantially
identical to those in Notice 2010-92, except that their scope is extended to cover taxes paid or accrued by persons other
than 902 corporations. The regulations also expand the types of loss-sharing arrangements that Notice 2010-92 treats as
splitter arrangements. Partnership inter branch payment splitter arrangements are another type of transaction described
in the Temporary Regulations.
b. Related Income and Split Taxes. The Temporary Regulations provide rules for determining related income and split
taxes and for coordinating the interaction between 909 and other Code provisions. The Temporary Regulations also
incorporate the guidance in Notice 2010-92 on the application of 909 to foreign income taxes paid or accrued by 902
corporations in pre-2011 tax years.
c. Similarity With Rules Contained in Notice 2010-92, supra. The Temporary Regulations provide rules substantially
similar to those in Notice 2010-92 on the application of 909 to partnerships and trusts, except that they expand the
scope of the rules to include S corporations and taxes paid or accrued by persons other than 902 corporations. Where
foreign income taxes are paid or accrued by a partnership, S corporation, or trust, taxes allocated to one or more
partners, shareholders, or beneficiaries will be treated as split taxes to the extent the taxes would be split taxes if the
partner, shareholder, or beneficiary had paid or accrued them directly on the date they are taken into account by the
partner, shareholder, or *105 beneficiary. Any split taxes will be suspended in the hands of the partner, shareholder,
or beneficiary. The Temporary Regulations to 909 also address the application of 909 to annual layers of pre-1987
accumulated profits and pre-1987 foreign income taxes of a 902 corporation.
d. Effective Date of Temporary Regulations to Section 909. The Temporary Regulations are effective February 14,
2012, and Notice 2010-92 is also obsolete as of that date.
e. Non-Application to Covered Asset Acquisitions in Section 901(m).
(1) Section 901(m). Also enacted as part of the 2010 EJMAA, P.L. 111-226, 212(a), 901(m), denies foreign tax
credits with respect to foreign income not subject to U.S. taxation by reason of covered asset acquisitions. Covered
asset acquisitions are acquisitions of assets that have in the aggregate a higher tax basis for U.S. tax purposes than
for foreign tax purposes, such as may occur as a result of a qualified 338(d)(3) stock purchase to which 338(a)
applies, an asset purchase for U.S. tax purposes that is treated as a stock purchase for foreign tax purposes (e.g., a
purchase of the stock of a disregarded entity), by the check-the-box election for U.S. tax purposes, or an acquisition
of an interest in a partnership that has a 754 election in effect. The loss of the FTC applies only to the extent of
the disqualified portion of the foreign income tax, which is the ratio that the aggregate basis differences in the
relevant foreign assets allocated to a given taxable year bear to the foreign income on which the tax was imposed.
901(m)(3)(A). See 901(m)(4)(definition of relevant foreign asset). The allocation of the basis differences is
generally accomplished using the applicable cost recovery method for the type of asset involved. 901(m)(3)(C)(i).
Basis differences themselves represent the excess of the adjusted basis of a given asset immediately after the covered
asset acquisition over the adjusted basis of that asset immediately before the covered asset acquisition. If the covered
asset acquisition is a qualified stock purchase, it will be deemed to have occurred at the close of the acquisition date.
901(m)(3)(C)(iii). Section 901(m) is effective for covered asset acquisitions occurring after Dec. 31, 2010, except
for any covered asset acquisition between unrelated parties that is: (1) made pursuant to a written agreement that was
binding on Jan. 1, 2011, and at all times thereafter; (2) described in an IRS ruling request submitted *106 by July 29,
2010; or (3) described in a public announcement or SEC filing by Jan. 1, 2011.
(2) Section 909 Temporary Regulations (2012). The 909 Temporary Regulations specifically exclude covered
asset acquisitions under 901(m) from the list of splitter arrangements. Citing increased complexity and
administrative burden, the IRS decided that applying 909 to covered asset acquisitions would not be appropriate.
T.D. 9577 (1/14/12). Still, 901(m) can apply to taxes paid or accrued in connection with a splitting event (e.g., a 338
election is made with respect to the acquisition of the interests in a reverse hybrid).
f. Identification in 2012 Temporary Regulations to Splitter-Events. Under Temp. Reg. 1.909-2T(b), foreign taxes
that are paid or accrued with respect to splitter arrangements are referred to as split taxes, and, the income or E&P to
which the foreign taxes relate is referred to as related income. The exclusive list of splitter arrangements identified in
the temporary regulations is as follows: (i) reverse hybrid splitter arrangements; (ii) loss-sharing splitter arrangements;
(iii) hybrid instrument splitter arrangements; and (iv) partnership inter-branch payment splitter arrangements. These
arrangements are applicable to foreign income taxes paid or accrued in taxable years beginning after December 31,
2011. Temp. Reg. 1.909-2T(c). The pre-2011 splitter arrangements also identified are the same as set forth in
Notice 2010-92, supra, and include: (i) reverse hybrid splitter arrangements; (ii) foreign consolidated group splitter
arrangements; (iii) group relief or other loss-sharing regime splitter arrangements; and (iv) hybrid instrument splitter
arrangements.
(1) Reverse hybrid splitter arrangements. The Temporary regulations define a reverse hybrid (an entity that is a
corporation for U.S. income tax purposes and fiscally transparent or a branch under foreign law) becomes a splitter
arrangement when a payor pays or accrues foreign income taxes with respect to income of the reverse hybrid. The
splitter exists even if the reverse hybrid has a loss or a deficit in E&P for a particular year for U.S. tax purposes. The
foreign taxes paid or accrued on the reverse hybrid's income are considered split taxes. The related income is the E&P
(computed for U.S. income tax purposes) of the reverse hybrid attributable to its activities that gave rise to income
included in the payor's foreign tax base. The Regulations also provide that the related income of the reverse hybrid
includes only items of income or expense *107 attributable to a disregarded entity owned by the reverse hybrid to the
extent that the income attributable to the activities of the disregarded entity is included in the payor's foreign tax base.
(2) Loss-sharing splitter arrangements. A foreign group relief or loss-sharing regime will be considered a loss-
sharing splitter arrangement under the Temp. Regs. to the extent that a shared loss of a U.S. combined income group
could have been used to offset income of that group but instead was used to offset income of another U.S. combined
income group. This definition has been expanded from that under Notice 2010-92, which applied only to shared losses
attributable to debt that was disregarded for U.S. tax purposes.
(1) Under the Temporary Regulations, a U.S. combined income group consists of a single individual or corporation
and all other entities (including fiscally transparent entities for U.S. tax purposes) that for U.S. income tax purposes
combine any of their respective items of income, deduction, gain, or loss with the income, deduction, gain, or loss
of such individual or corporation. The income of a U.S. combined group consists of the aggregate amount of taxable
income of the members of the group that have positive taxable income, computed under applicable foreign law
(Temp. Reg. 1.909-2T(b)(2)(iii)(A)). The shared loss of a U.S. combined income group is the sum of the shared
losses of all members of the group (Temp. Reg. 1.909-2T(b)(2)(iii)(B)).
(2) Where an entity is fiscally transparent for foreign tax purposes and is a member of more than one U.S. combined
income group, the foreign taxable income or shared loss of the entity is to be allocated between or among the groups
under foreign tax law. For an entity that is not fiscally transparent for foreign tax purposes and is a member of more
than one U.S. combined income group, the entity's foreign taxable income or shared loss is allocated between the
separate U.S. combined income groups under U.S. income tax principles. In the latter case, although the allocation
is based on U.S. tax principles, the amount of foreign taxable income or shared loss is allocated under foreign law.
*108 (3) Hybrid instrument splitter arrangements. The definition of hybrid instrument splitter arrangements under
the Temporary Regulations is substantially identical to that established in Notice 2010-92, except that the scope is
extended to cover taxes paid or accrued by persons other than 902 corporations.
(1) U.S. equity hybrid instrument. A U.S. equity hybrid instrument is an instrument that is treated as equity for
U.S. income tax purposes but as debt for foreign tax purposes, or with respect to which the issuer is otherwise entitled
to a deduction for foreign tax purposes. A U.S. debt hybrid instrument is defined as an instrument that is treated
as equity for foreign tax purposes but as debt for U.S. tax purposes. A U.S. equity hybrid instrument is a splitter
arrangement if foreign income taxes are paid/accrued by the owner of the instrument with respect to payments or
accruals on or with respect to the instrument that are deductible by the issuer under the laws of a foreign jurisdiction
in which the issuer is subject to tax but that do not give rise to income for U.S. tax purposes.
(2) U.S. hybrid debt instrument. A U.S. debt hybrid instrument is a splitter arrangement if foreign income taxes
are paid/accrued by the issuer of the instrument with respect to income in an amount equal to the interest (including
original issue discount) paid/accrued on the instrument that is deductible for U.S. tax purposes but not deductible
under applicable foreign law.
(4) Partnership inter-branch payment splitter arrangements. The Temporary Regulations provide that an allocation
of foreign income tax paid/accrued by a partnership with respect to an inter-branch payment as described in Reg.
1.704-l(b)(4)(viii)(d)(3) is a splitter arrangement to the extent that the inter-branch payment tax is not allocated to the
partners in the same proportion as the distributive shares of income in the creditable foreign tax expenditure (CFTE)
category to which the inter-branch payment tax is or would be assigned. The Regulations provide details on calculating
split taxes and related income from a partnership inter-branch payment splitter arrangement.
*109 g. Future Guidance on Section 909. The Preamble to TD 9577 says that future guidance may identify additional
transactions or arrangements to which Section 909 applies. The splitter arrangements described in Temp. Reg. 1.909-2T
apply to foreign income taxes paid or accrued in tax years beginning on or after January 1, 2012. The Temporary
Regulations also provide rules for determining related income and split taxes and for coordinating the interaction between
Section 909 and other Code sections.
h. Temp. Regs. 1.909-lT(b) and (c). These regulations provide rules substantially similar to those in Notice 2010-92
on the application of Section 909 to partnerships and trusts, except that the Temporary Regulations expand the scope of
the rules to include S corporations and taxes paid or accrued by persons other than Section 902 corporations. Temp. Reg.
1.909-lT(b) provides that Section 909 applies at the partner level, and similar rules apply for an S corporation or trust.
(1) Reconciling the Temporary Regulations to Section 909 and Notice 2012-92, and in particular, 4.06 of Notice
2010-92 The Preamble to the Temporary Regulations to 909 states that guidance on determining the amount of related
income and pre-2011 split taxes paid or accrued with respect to pre-2011 splitter arrangements will be forthcoming,
including determining the amount of related income and split taxes attributable to a foreign tax credit splitting event.
Until such guidance is issued, Temp. Reg. 1.909-3T(a) provides that the principles of Temp. Regs. 1.909-6T(d)
through 1.909-6T(f) (which adopt the rules described in section 4.06 of Notice 2010-92) will apply to related income
and split taxes in taxable years beginning on or after January 1, 2011, except that the alternative related income first
method described in Temp. Reg. 1.909-6T(d)(4) (which adopts section 4.06(b)(4) of Notice 2010-92) for identifying
distributions of related income applies only to identify the amount of pre-2011 split taxes of a 902 corporation that
are suspended as of the first day of the 902 corporation's first taxable year beginning on or after January 1, 2011.
The Temporary Regulations, in Temp. Reg. 1.909-3T(b), in going beyond Notice 2010-92, provides that split taxes
include taxes paid or accrued in taxable years beginning on or after January 1, 2011, with respect to the amount of a
disregarded payment that is deductible by the payor of the disregarded payment under the laws of a foreign jurisdiction
in which the payor of the disregarded payment is subject to tax on related income *110 from a splitter arrangement.
The amount of the deductible disregarded payment to which this rule applies is limited to the amount of related income
from such splitter arrangement.
In addition to future guidance on determining the amount of related income and split taxes, the Treasury Department
and the IRS expect to issue regulations that provide additional guidance on the interaction between 909 and other Code
provisions such as 904(c), 905(a), and 905(c). Until such guidance is issued, Temp. Reg. 1.909-4T(a) provides
that the principles of Temp. Reg. 1.909-6T(g), which adopt the rules described in section 6 of Notice 2010-92, will
apply to taxable years beginning on or after January 1,2011.
As mentioned, Section 909 applies to foreign income taxes paid or accrued in taxable years beginning after December
31, 2010. Temp. Reg. 1.909-2T(b), sets forth the exclusive list of splitter arrangements, is effective for foreign income
taxes paid or accrued in taxable years beginning on or after January 1, 2012. Notice 2010-92 states that pre-2011
splitter arrangements will give rise to foreign tax credit splitting events in post-2010 taxable years. Accordingly, Temp.
Reg. 1.909-5T(a)(l) provides that foreign income taxes paid or accrued by any person in a taxable year beginning on
or after January 1, 2011, and before January 1, 2012, in connection with a pre-2011 splitter arrangement (as defined in
Temp. Reg. 1.909-6T(b)), are split taxes to the same extent that such taxes would have been treated as pre-2011 split
taxes if such taxes were paid or accrued by a section 902 corporation in a pre-2011 taxable year. The related income
with respect to split taxes from such an arrangement is the related income described in 1.909-6T(b), determined as
if the payor were a section 902 corporation.
In addition, Notice 2010-92 states that allocations described in 1.704-l(b)(4)(viii)(d)(3) will result in a foreign tax
credit splitting event in post-2010 taxable years to the extent such allocations result in foreign income taxes being
allocated to a different partner than the related income. Temp. Reg. 1.909-5T(a)(2) provides that foreign income
taxes paid or accrued by any person in a taxable year beginning on or after January 1, 2011, and before January 1,
2012, in connection with a partnership inter-branch payment splitter arrangement described in Temp. Reg. *111
1.909-2T(b)(4) are split taxes to the extent such taxes are identified as split taxes in Temp. Reg. 1.909-2T(b)(4)(ii).
The related income with respect to the split taxes is the related income described in Temp. Reg 1.909-2T(b)(4)(iii).
The temporary regulations to 909 provide that foreign income taxes paid or accrued by any person in a taxable year
beginning on or after January 1, 2012, and on or before February 14, 2012 in connection with a foreign consolidated
group splitter arrangement described in 1.909-6T(b)(2) are split taxes to the same extent that such taxes would have
been treated as pre-2011 split taxes if such taxes were paid or accrued by a section 902 corporation in a pre-2011
taxable year. This rule ensures that section 909 applies to suspend foreign tax on income of foreign consolidated groups
paid or accrued in post-2010 taxable years to the extent the tax is not apportioned among the members of the group
in accordance with the principles of Treas. Reg. 1.901-2(f)(3). Final regulations published elsewhere in this issue of
the Federal Register explicitly apply the ratable allocation rules of Treas. Reg. 1.901-2(f)(3) to tax paid on combined
income of foreign consolidated groups, without regard to whether the group members are jointly and severally liable
for the tax under foreign law.
VIII. OTHER SPECIAL LIMITATIONS
A. Oil and Gas Income.
1. Background. In many countries, the government owns all mineral resources and is in the position to collect royalties
as well as tax from the U.S. oil companies engaged in the business of extracting the oil. Thus, the foreign government
can classify as a tax what is essentially a proprietor's royalties in dealings between private parties. If this formalistic
classification of the payment as a tax rather than as a royalty were upheld, U.S. oil companies dealing with oil exporting
countries would get a full reduction of U.S. taxes for payments that would otherwise only be deductible as royalties.
Congress began to react to this practice of characterizing royalties as taxes. Section 907, enacted by the Tax Reduction
Act of 1975, restricts the amount of credit that can be taken under 901 for foreign taxes paid or accrued. It allocates oil
and gas income to their own baskets of income called foreign oil and gas extraction income FOGEI and foreign oil-related
income (FORI). It then *112 limits the amount of credit that can be taken for taxes paid or accrued on those baskets.
2. FOGEI. Foreign oil and gas extraction income includes six general categories, the primary one of which is gross
income from the extraction from oil and gas wells located outside the United States and its possessions. For the corporate
taxpayer, the amount of oil and gas extraction taxes paid is:
FOGEI * highest corporate rate under I.R.C. 11(b)
FOGEI generates a foreign tax credit only to the extent the foreign taxes on that income do not exceed the U.S. taxes
applicable to that income. Excess foreign tax credits may be carried back two years or forward five years respectively.
3. FORI. The difference between FORI and FOGEI is that tax on FORI is a substitute for royalty payments; it is not
treated as a tax at all but rather as a deductible expense. FORI income is derived from the processing as distinguished from
the extraction of oil and gas.
B. Alternative Minimum Tax.
The purpose of the AMT is to require taxpayers to pay a minimum level of tax on their gross income. The AMT is 20%
for corporations (28% for individuals) reduced by the alternative minimum foreign tax credit for the taxable year. Even if
the taxpayer's regular income tax liability is fully offset by foreign tax credits, the AMT rules have limitation rules so that
the taxpayer has to pay some federal tax. For taxable years beginning before January 1, 2005, the alternative minimum tax
credit was, with one narrow exception, not to exceed 90% of the AMT. AJCA 2004 repealed this limitation for subsequent
taxable years.
C. Step-Up Acquisitions.
Section 901(m) was added to the Code in 2010 to reduce the foreign tax credit otherwise allowable after a covered asset
acquisition of overseas assets in which there is a step-up in asset the tax bases of those assets for U.S. tax purposes but not
for foreign tax purposes (for example, as a consequence of a 338(g) election).
IX. PROCEDURAL ISSUES
A. Forms.
The taxpayer must submit any claims for the foreign tax credit on Form 1116 (for individuals) or Form 1118 (for
corporations) with its tax return; both forms, with *113 their accompanying instructions, are reproduced at the end of this
outline. The taxpayer must include a receipt for the taxes actually paid or the foreign tax return on which the accrued tax is
based. If the documents are not in English, the taxpayer must supply a certified translation. The receipt or the return must
be the original, a duplicate original, or a duly certified or authenticated copy. If the taxpayer cannot reasonably obtain the
receipt or return, certain types of secondary evidence are acceptable.
B. Carryback/Carryforward of Excess Foreign Tax Credits.
Any foreign tax credit that exceeds the U.S. tax on income in any basket may be carried back for one year or carried
forward for ten years to absorb excess U.S. tax on income in that same basket. The taxpayer first determines the amount of
the creditable taxes paid or accrued during the tax year involved. Second, it allocates the foreign taxes to the appropriate
limitation basket based on the classification of income from foreign sources. Third, it determines if any foreign tax exceeds
the limitation provision of any basket. If it paid or accrued more taxes in any basket than it is permitted to credit, the taxpayer
has generated an excess foreign tax credit on in that basket. (Prior to the enactment of AJCA 2004, the carryback period was
two years and the carryforward period was five years.)
C. Subsequent Adjustments.
A foreign taxing authority may change the amount of foreign tax owed by a U.S. taxpayer (or a foreign corporation from
which the U.S. taxpayer can derive an indirect FTC) after the taxpayer has filed its U.S. tax return for the year in question.
Section 905 and the regulations thereunder govern the methods for dealing with previously claimed FTCs in the event of
such a later adjustment.
D. Limitations Period.
The taxpayer has a ten-year period in which to elect to take the credit or deduct the foreign tax, or to claim a refund. The
limitations period begins to run with the year in which the foreign taxes were paid or accrued.
*****
*114 U.S. Treasury Circular 230 Notice
Any U.S. federal tax advice included in this communication (including any attachments) was not intended or written to be
used, and cannot be used, for the purpose of (i) avoiding U.S. federal tax-related penalties or (ii) promoting, marketing or
recommending to another party any tax-related matter addressed herein.
[FNa1]. It is noteworthy that a leading treatise on this subject was written by Richard E. Andersen, Foreign Tax Credits,
Warren Gorham & Lamont (2013).
VCVG0919 ALI-ABA 1

Foreign Tax Credits - Planning and Pitfalls

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