Tax Law--Second Circuit Accurately Applies the Economic Substance Doctrine to Foreign Tax Credits--Bank of New York Mellon Corp. v. C.I.R., 801 F.3d 104 (2d Cir. 2015).

• Author: Lubrano, Christopher J.

Through the colonial period to the founding of the country, taxation has been an essential part of U.S. history; the U.S. Constitution laid out by the founding fathers gave the federal government the right to tax the citizens of the nation. (1) Taxation has changed substantially throughout U.S. history and has become more complex over the years. (2) Now, all fifty states and the federal government impose income taxes on business transactions that occur both in the United States and abroad. (3) In Bank of New York Mellon Corp. v. C.I.R, (4) the United States Court of Appeals for the Second Circuit considered whether the economic substance doctrine could be applied to the foreign tax credits that the Bank of New York Mellon (BNY) and American International Group (AIG) had taken in their separate cross-border transactions. (5) The Second Circuit held that the economic substance doctrine could be applied to foreign tax credits, determining both corporations' transactions to be sham transactions. (6)

From the 1993 to 1997, AIG entered into six foreign transactions using a subsidiary, AIG Financial Products (AIG-Financial), to set up a special purpose vehicle (SPV) to hold and invest funds in a foreign country. (7) Preferred shares of the SPV were sold to a foreign bank and AIG-Financial committed to repurchasing the shares at a specific future date. (8) The SPV paid taxes on its earnings to the appropriate foreign authority, and AIG claimed that it owned all of the shares of the SPV for U.S. tax purposes. (9) AIG claimed foreign tax credits for the entire amount of taxes paid by the SPV, which it used to offset both the foreign taxes paid as well as taxes due on unrelated transactions. (10) Simultaneously, the foreign banks treated the SPV as its corporate subsidiary and treated the SPV's distributions as tax-exempt dividends, which generated very little tax. (11) Through these transactions, AIG was able to convert interest expenses it would have had to pay to foreign banks into foreign tax credits that it used to reduce its total tax bill. (12)

For a period of five years, 2001 through 2006, BNY engaged in transactions known as Structured Trust Advantaged Repackaged Securities (STARS) with Barclays Bank (Barclays). (13) The first step in the STARS transaction required BNY to create a Delaware trust in which it contributed USD7.8 billion in income producing assets in exchange for shares in the trust; BNY appointed a U.K. trustee in order for the trust to be subject to U.K. taxes. (14) Barclays then purchased class C and D shares in the trust, which BNY agreed to pay back at the end of the five-year period. (15) Throughout the duration of the contract, the trust made monthly payments of income by using a circular multistep process. (16) Both BNY and Barclays generated tax benefits from these transactions; BNY generated a total net gain due to the tax spread and claiming a foreign tax credit for the total amount paid in U.K. taxes, despite Barclays reimbursing it for half. (17)

AIG and BNY appealed the decisions of the lower courts. (18) Both AIG and BNY believe themselves to be entitled to foreign tax credits for transactions entered into abroad. (19) AIG appealed the decision from the United States District Court for the Southern District of New York, which held that the economic substance doctrine applied to foreign tax credits involved in their foreign transaction. (20) The United States Tax Court held that the tax spread in BNY's transaction should be included in taxable income because it lacked economic substance. (21) As both of these cases present issues of economic substance, the Second Circuit heard them in tandem. (22)

The Internal Revenue Code allows for individuals and corporations to receive tax credits for taxes paid to foreign countries; these credits have opened the gate for corporations to search for advantageous transactions to receive further benefits. (23) In order to combat corporations engaging in activities for strictly tax benefit purposes, the common law economic substance doctrine was developed. (24) The Supreme Court of the United States, in Frank Lyon Co. v. United States, (25) gave the economic substance test a distinctive form. (26) The test has evolved into a two-prong test: the objective test and subjective test. (27) Despite having two tests, courts have applied the tests inconsistently, and sometimes only applying the objective test in order to determine whether the transaction is a "sham" transaction. (28) In 2010, Congress codified the economic substance doctrine in the Healthcare and Education Affairs Reconciliation Act of 2010, as it appeared in the Supreme Court's decision is Frank Lyon. (29)

The objective prong of the economic substance doctrine asks whether a "reasonable possibility of profit from the transaction existed apart from tax benefits." (30) The major issue with the application of the objective prong is determining how related the entirety of the transaction must be to the economic benefit realized. (31) Courts have taken different approaches in analyzing the transaction using the objective prong, one of which looks to the economic position of the taxpayer and the potential profitability of the transaction outside of tax benefits. (32) Another narrower standard that the courts use is if there is a potential for there to be economic benefit from the transaction; a benefit can be derived simply by incorporating a business, something that does not necessarily cause an increase in profit. (33) The narrowest view that the courts take requires an analysis of the profit that could be expected from engaging in the transaction. (34)

The second prong of the economic substance doctrine is the subjective test. (35) The subjective test seeks to determine if there is a legitimate business purpose for entering the transaction. (36) Courts often focus on the profit motive behind the taxpayer entering the transaction; however, there are circumstances in which the courts will find a legitimate business purpose without looking to the profit motive. (37) Over time, the subjective test has met criticism about questioning a taxpayer's motive for entering a transaction because it is difficult to determine a taxpayer's true intentions. (38)

In Bank of New York Mellon Corp. v. C.I.R, the Second Circuit addressed whether the United States Tax Court and the District Court for the Southern District of New York properly applied the economic substance doctrine to transactions involving foreign tax credits. (39) The Court began its analysis of the AIG transaction under the objective prong of the economic substance doctrine. (40) In order to address issues of material fact surrounding the objective economic test, the Court turned to the government's economist for analysis of AIG's transaction, which it determined there to be minimal economic benefit, if any, outside of the tax benefits. (41) The court also determined that the SPV did not have any independent economic benefit; the SPV would not have had sufficient cash flows without the contributions from AIG and generated no independent economic return leading the court to determine that there was no objective economic substance. (42) Under the subjective prong, the Court began its analysis by looking at AIG's internal documents that discuss the transactions as being "tax driven." (43) The Court also noted that AIG-Financial reserved the right to end transactions if they were no longer able to obtain tax benefits, leading the court to determine the transaction lacked subjective economic substance, thereby holding the transaction to be a sham. (44)

The Court began analyzing the BNY transaction by explaining that the Tax Court appropriately analyzed the STARS trust separately from the USD 1.5 billion loan the corporation made because the tax benefits from each are distinct. (45) The Court began its objective prong analysis by viewing the trust's transaction and stated that it is appropriate to exclude foreign taxes when calculating pretax profit in order to determine if there was a reasonable expectation of earning an objective profit. (46) The Court next explained that when reviewing the transaction as a whole for economic profit, it is appropriate to remove tax profit from a calculation of profit, which lead there to be no real profit potential for the transaction and it was truly used for the tax benefits which came from it. (47) The Court noted that profit should not be the only factor within the objective analysis; the Court viewed the circular cash flows as clearly indicating that the transaction was done purely to gain tax benefits. (48) In moving to the subjective prong of the economic substance doctrine, the Court's holding agreed with the Tax Court in that BNY's only subjective reasoning for entering the transaction was to receive a tax benefit. (49) The Court reasoned that BNY's stated purpose of obtaining a "low cost" loan was only obtainable through the use of tax spread and BNY's global tax director had stated that entering the STARS transaction was predicated on using foreign tax benefits. (50)

The Second Circuit's analysis of transactions entered into by BNY and AIG, using the economic substance doctrine, was accurate. (51) The Court's explanation and in-depth analysis of the objective prong was appropriate and necessary in determining whether the transaction was a sham. (52) The Second Circuit appropriately acknowledged that the objective test has many forms and the transaction's potential profitability is not the only aspect of the transaction that should be inquired into. (53) Although the Court never directly states it, it moved towards using a factor test, which views the transaction as a whole, looking at all aspects and not just profit, in order to determine if both AIG's...