'FTC Generator' Case Update

On May 18, 2015, two foreign tax credit ("FTC Generator") cases were argued before the Second Circuit Court of Appeals.6 In both cases, Bank of New York Mellon and American International Group, the taxpayer lost the FTC Generator issue in the lower court. In Bank of New York Mellon, the Tax Court held that a structured trust advantaged repackaged securities ("STARS") deal lacked economic substance (pre-codification under Section 7701). Consequently, the court held BNY could not claim foreign tax credits or deductions for expenses related to the transaction, and income from the transaction was treated as US-source income.

Bank of New York Mellon

The STARS transaction was structured to provide BNY with below market cost financing. The complex transaction structure involved BNY transferring income-producing property into a trust subject to UK tax. As part of the transaction, BNY entered into forward sale agreements, a zero coupon swap agreement, a credit default swap and security arrangements with a British bank. The arrangements created a $1.5 billion secured loan from the British bank to BNY.

As a result of the STARS transaction, BNY claimed foreign tax credits of approximately $200 million and expense deductions of approximately $7.6 million in 2001 and 2002. BNY also reported the income from the assets transferred to the trust as foreign sourced.

The Tax Court shot down the STARS transaction under the economic substance doctrine. Under the objective prong of the doctrine, the Tax Court held that the STARS structure lacked economic substance because BNY did not have a reasonable expectation of making a non-tax profit by using the STARS structure. The court explained that the STARS structure did not increase the profitability of BNY's income-producing assets, and the structure's main activity was circulating income. The Tax Court refused to take into account the profit from the STARS assets when evaluating the transaction, stating that "[e]conomic benefits that would result independent of a transaction do not constitute a non-tax benefit for purposes of testing its economic substance."7

When evaluating the structure under the objective prong, the Tax Court followed its holding in Compaq Computer Corp. v. Commissioner8, which held that foreign taxes are treated the same as any other transaction cost when determining whether the transaction makes economic sense. The Tax Court acknowledged that "the Court of Appeals for the Fifth and Eighth...