On Feb. 11, 2013, a regular Tax Court opinion was issued in a case that the opinion said was of first impression, ruling against Bank of New York Mellon (BNY). 140 T.C. No. 2. BNY had engaged in a cross-border transaction called STARS that KPMG created around 2000 in cooperation with the foreign bank Barclays. Barclays desired to obtain UK tax credits and deductions that required making an investment in a UK trust in conjunction with investments by a U.S. bank. The benefit for the U.S. bank was to be receipt as a loan of Barclays’ investment of $1.5 billion in the trust, with a very reduced interest rate.
Facts. In order for Barclays to obtain its UK tax benefits, BNY’s investment in the UK trust had to produce income taxed in the United Kingdom and the United States. BNY claimed foreign tax credits in the United States. In addition, part of the total income in the years at issue was income that was accelerated in the trust for UK tax purposes, on which the trust paid additional UK tax. However, the accelerated income was not taxed at that time in the United States. BNY also claimed foreign tax credits for those taxes.
Court’s Reasoning. The IRS asserted that BNY’s investment in the trust was subject to the economic substance doctrine. The Tax Court agreed. As a result, the Tax Court disallowed all foreign tax credits claimed by BNY, denied an alternate Section 164 deduction for the foreign taxes BNY paid and denied a deduction for interest BNY paid on the loan and other expenses.
The Tax Court’s ground for ruling that the economic substance doctrine applied was that it found BNY failed to prove a satisfactory business purpose or profit potential for its investment in the UK trust. The court refused to view obtaining the below-market loan of $1.5 billion as a business purpose, because it was not necessary to the part of the bifurcated transaction that produced the tax benefit.
A&B Analysis. The court’s reasoning could be analyzed in several respects: Did the court properly bifurcate the transaction? Did the court properly account for foreign taxes in its analysis? Did the court properly evaluate the taxpayer’s evidence? However, these issues are by far less significant as a matter of tax policy than an issue that is not so apparent from the face of the opinion: Is it the function of the economic substance doctrine to punish a taxpayer who cannot prove out of the two-prong test once the doctrine is asserted or is it the function of the doctrine to find whether facts occurred that are required for a taxpayer to claim certain tax benefits?
The Tax Court in BNY in effect applied the economic substance doctrine as a penalty to punish a taxpayer, rather than as a fact-finding tool. The U.S. tax benefit BNY claimed was principally the foreign tax credit. There was no dispute that the foreign tax was paid, BNY was properly treated as paying it, BNY bore the economic burden of the foreign tax and—during the year at issue—no statute, regulation or other rule of law existed to deny the use of the credit.
Rather, the court simply found that BNY had no business purpose or profit potential for moving its income producing assets to the UK trust and for that reason should be denied the foreign tax credits. The court ignored the below-market loan because it ruled that was the way the economic substance doctrine purpose and profit analysis is supposed to work.
The distinction between using the doctrine as a penalty and as a fact-finding tool is admittedly subtle. It is so subtle that Congress chose not to tackle defining the doctrine and stating when it was relevant in Section 7701(o). However, Section 7701(o) is a strong indicator that Congress viewed the doctrine as a fact-finding tool, rather than a positive rule of law. It is highly unlikely that Congress would have delegated to courts the power to punish taxpayers, without even providing guidelines as to when the power should be exercised. But it is more likely that Congress would have supported the courts’ development of a fact-finding methodology by approving it, defining it and leaving its applicability to be fleshed out by the courts that had originally developed it.
A clear example of the difference between the two approaches to the doctrine can be seen by comparing the BNY ruling with the most prominent foreign tax credit generator cases that went the other way, Compaq and IES. The appellate opinion in Compaq stated:
Turning first to economic substance, the [IES] court rejected the argument that the taxpayer purchased only the right to the net dividend, not the gross dividend. “[T]he economic benefit to IES was the amount of the gross dividend, before the foreign taxes were paid. IES was the legal owner of the ADRs on the record date. Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 783 (5th Cir. 2001), reversing, 113 T.C. 214 (1999). See also IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001).
That is, in Compaq and IES, the government argued that as a matter of fact the taxpayer did not buy and own the dividend payable on the stock that it bought, and for that reason the taxpayer was not entitled to a foreign tax credit for the tax on the dividend. The appellate courts ruled that as a matter of fact the taxpayers bought the dividends. Therefore the purchase of the dividend was not a factual “sham.” These cases involved a more proper application of the economic substance doctrine as a shortcut tool to find facts in ambiguous situations where taxpayers’ use of a tax benefit depends on the existence of certain facts: Was money borrowed? Was insurance bought? Was a loss sustained?
Conclusion. The BNY foreign tax credit did not depend on proof of any such relevant fact. BNY paid the foreign tax. The Tax Court denied to BNY the use of the credit simply because it did not like the fact that BNY had borrowed money cheaply by enabling Barclays to claim UK tax benefits. The Tax Court thereby transmuted a fact-finding methodology, or presumption that is triggered by the taxpayer’s failure to prove certain mega facts, into a freestanding penalty that Congress did not impose.
