Tax Court Sides With Service In Holding That A STARS Transaction Entered Into By Bank Of New York Lacked Economic Substance Despite Transactions Literal Compliance With Code

In Bank of New York Mellon Corporation, Successor in Interest to the Bank of New York, Company, Inc. ("BNY") v. Commissioner, 140 T.C. No. 2; No. 26683-09 (filed 2/11/2013), the Tax Court, in a fully reviewed decision with Judge Diane L. Kroupa writing for the majority, upheld a proposed deficiency in federal income tax against the BNY consolidated group for 2001 and 2002 in the amount of $100 million (2001) and $115 million (2002). It should be expected that BNY will appeal to the Second Circuit Court of Appeals.

The case involved BNY's entering into a Structured Trust Advantaged Repackaged Securities transaction (STARS transaction). The STARS transaction provided BNY with allegedly below market cost financing from a U.K. bank, Barclays. It was part of a set of steps to generated foreign source income and foreign tax credits and expenses to BNY in a tax-arbitrage type play that the government would attack as lacking any economic substance other than to generate tax savings.

As part of the STARS transaction, BNY transferred income-producing assets to a trust with a U.K. trustee and subject the trust asstes to U.K. tax on its income. As a result, BNY claimed foreign tax credits and deductible expenses on its 2001 and 2002 consolidated income tax returns as a result of the STARS transaction. It further reported income from the assets transferred to the trust as foreign source income on the returns.

Upon audit, the government alleged that the STARS transaction was a sham and lacked economic substance. It therefore disallowed the claimed foreign tax credits, the expense deductions and the reporting of the asset income as foreign source. The Court ruled that since the STARS transaction, based on the record before it, lacked economic substance and could not be respected for federal tax purposes, including treaty purposes. Accordingly, BNY could not claim foreign tax credits, the claimed deductible expenses or the foreign source income treatment.

The affiliated group through BNY entered into the STARS transaction in 2001 with Barclays Bank, PLC (Barclays), a global financial services company headquartered in London, United Kingdom. The STARS transaction generated approximately $199 million in foreign tax credits for the combined years at issue. The opinion sets forth the background leading up to the structuring and implementation of the STARS transaction. The key players were of course BNY, Barclays and KPMG, STARS was represented as a "below market loan" in KPMG's initial presentation. KPMG indicated that STARS required a U.K. counterparty and a certain trust structure holding income-producing assets. KPMG explained that the below-market cost would be achieved by the U.K. counter party "sharing" U.K. tax benefits from STARS through an offset to the cost of the loan. Finally, KPMG indicated that the U.K. tax benefits would be generated by subjecting income-producing assets held by a trust to U.K. tax and thus generating foreign tax credits that BNY could use to offset its U.S. tax liability.

BNY notified KPMG in August 2001 that it was prepared to move forward with a STARS transaction with Barclays as the U.K. counterparty. BNY proposed that it would contribute assets that would generate $93 million of annual U.K. tax costs and expected Barclays to reduce the loan's annual cost by half that amount. Shortly thereafter, BNY agreed to supplement STARS by engaging in a "stripping transaction." The effect would be to accelerate and increase the tax benefits STARS produced (i.e., foreign tax credits). And just before STARS closed, BNY indicated to Barclays that it had decided to increase the targeted benefit.

The specific components of the STARS transaction are chronicled in the factual background provided by the Court in rendering its decision. The interested reader should review carefully the Courts description of the transaction, including transaction models . The Tax Court noted that the STARS transaction represented a case of first impression for it to decide.

Tax Court's Analysis

1. Merits of...