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Tax Law

STARS Transaction Lacks Economic Substance

Although the economic substance doctrine has been recognized by the courts for a long time and was codified as IRC Section 7701(o) in 2010, it has not stopped taxpayers from trying to avoid or reduce tax liability through creative structuring of various types of transactions.  However, the IRS has taken full advantage of the economic substance doctrine to subject taxpayers to the economic reality of the transaction.  A recent example of this is Bank of New York Mellon Corp et al v Commissioner, 140 TC No 2. In Bank of New York Mellon Corp., the Tax Court determined that the bank was unable to claim foreign tax credits or business expense deductions related to a structured trust advantaged repackaged securities (STARS) transaction because the transaction lacked economic substance.

The IRS issued Bank of New York Mellon Corporation (BNY) a deficiency notice resulting from BNY's participation in a STARS transaction.  The transaction was composed of five complex steps involving a below-market loan and a transfer of income-producing assets to a trust with a U.K. trustee.  BNY claimed on its returns $199 million in U.S. foreign tax credits over two tax years and related expenses deductions. The IRS disallowed both the foreign tax credits and expense deductions.

In upholding the IRS' determination, the Tax Court found that although the transaction was structured to satisfy the requirements of the code and regulations, it consisted of an elaborate series of steps to disguise the generation and transfer of foreign tax credits and lacked economic substance. The Tax Court determined that the STARS transaction lacked objective economic substance because there was no reasonable opportunity for economic profit other than tax benefits. The court also determined that the transaction lacked subjective economic substance because there was no legitimate nontax business purpose for the transaction and the purpose for entering the transaction was tax avoidance.

BNY attempted to argue that the transaction had economic substance because the assets transferred to the trust as part of the transaction provided a potential for profits. Further, a loan made to the taxpayer from Barclays as part of the transaction gave the transaction economic substance because the loan was contingent on the STARS structure, and making a routine business transaction contingent on an economically meaningless transaction did not establish a reasonable nexus between them. BNY also argued that Congress intended the foreign tax credit to apply in STARS-type transactions because the credit was intended to alleviate the burden of double taxation for corporations with foreign business operations and not to transactions like STARS that involve no substantive foreign activity.  The court rejected all of BNY's arguments.
Although taxpayers may structure business transactions in a manner that results in the least amount of tax, the taxpayer must beware that even if a transaction complies literally with the Code, it does not necessarily follow that the tax benefit will be allowed.  

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