District Court Upholds STARS Transaction Ruling Payment Is Included

On October 17, 2013, Judge George A. O'Toole of the US District Court of Massachusetts issued an opinion holding that a structured trust advantaged repackaged securities ("STARS") transaction entered into by Sovereign Bancorp, Inc. (now known as Santander Holdings USA, Inc.) ("Sovereign") was not a sham, but rather had objective economic substance as a result of a payment Sovereign received from the counterparty which was included in Sovereign's pre-tax profit. 1 The opinion was consistent with the remarks of the district court judge in a September 25, 2013 pretrial conference when ruling that Sovereign's motion for partial summary judgment would be granted.2 The ruling marks a significant taxpayer victory in the so-called "foreign tax credit generator" cases.

Background

The STARS transaction involved a complex structure in which Sovereign transferred $6.7 billion in income-producing property to a trust subject to UK income tax. The income from the trust, which was attributed to Sovereign, was also subject to US income tax, and Sovereign claimed a foreign tax credit under section 901 for the. amount of UK income taxes paid.3 The transaction allowed the counterparty to obtain favorable UK tax treatment and, as a result of the favorable tax treatment, the counterparty extended a loan to Sovereign at a below-market rate. As part of the loan, the counterparty made a payment to Sovereign equal to one-half of the amount of UK income taxes paid on the trust income.

The government asserted that the payment from the counterparty to Sovereign should be excluded from Sovereign's calculation of pre-tax profit as an "effective rebate," which would mean that Sovereign did not in substance pay one-half of the UK taxes. According to the government, because the payment was an effective rebate and, as such, a "tax effect," the transaction failed the objective economic substance doctrine as it did not have a reasonable possibility of a pre-tax profit.

Rebate and Pre-Tax Profit Analysis

The district court concluded that the government's rebate argument was "wholly unconvincing" in light of the explicit provisions in the Code and the regulations addressing when a payment of foreign taxes may be considered rebated to the taxpayer. The court disregarded the expert witness testimony of the government regarding whether the payment was a rebate, explaining that the question is not one of fact for an expert witness, but rather a question of law to be answered by the...