Advisories December 1, 2015

Federal Tax Advisory: Economic Substance Doctrine Cases

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Things are heating up in the economic substance doctrine area, which could lead to a U.S. Supreme Court review of the IRS’s aggressive arguments for the doctrine.

Certiorari Petitions

Salem Financial Inc. and Bank of New York Mellon Corporation have both petitioned for Supreme Court review of the Federal Circuit and Second Circuit decisions against them, and American International Group Inc. has also petitioned for review of the Second Circuit decision against it. In all three of these cases, the IRS denied the use of foreign tax credits, not because foreign taxes were not paid, but because the taxpayers got some ancillary economic benefit in the deal that generated the foreign tax credits. It is critically important to understand that in these cases the taxpayers’ income was subject to both U.S. and foreign tax, and all the taxpayers did was claim the foreign tax credit to avoid double taxation.

The Salem and BNY cases involved what was called the “STARS transaction.” The AIG case involved a different sort of transaction that had similar features. All three financial institutions received large loans. As an economic matter, the net interest they paid on the loans turned out to be substantially below market; in other words, the borrowings were good deals for these taxpayers. 

The “price” of the good deals was subjecting some of their assets to foreign taxation in a venture with the lender, a foreign bank. That didn’t cost the taxpayers anything, but provided a foreign tax benefit to the foreign banks for reasons that don’t need to be detailed. The foreign banks shared their windfall with the taxpayers through payments that effected the reduced interest rates.

The IRS viewed the payments as offsetting dollar for dollar the taxpayers’ foreign taxes, rather than as interest rate reductions, or even fees for facilitating a foreign tax avoidance scheme. There was no good explanation why the payments should be so treated aside from the smell of the transactions as structured deals resulting in less tax paid to the United States; but of course the less tax was not less tax owing by the taxpayers. 

Now all three of these taxpayers want the Supreme Court to review their losses. That is not surprising because they have, or claim they have, the best reason that an appellant can give to the Supreme Court: a split in the circuits. The split is with the decisions over a decade ago in cases involving IES and Compaq. The courts of appeal allowed them to claim foreign tax credits with respect to dividends on stock bought in the market and held for a short period of time. The IRS viewed the transactions as track shelters; the taxpayers viewed them as normal applications of the dividend and foreign tax credit rules. 

The connection between the two sets of cases is that in each, the IRS wanted the profitability of the transactions to be determined by counting the foreign tax paid as an expense and not giving credit for the credit. It is readily apparent that such a method will tend to make all foreign investments uneconomic. The taxpayers have asserted the counting issue as the grounds for certiorari that reflects a conflict in the circuits. 

However, the counting issue is not necessarily the cause of the taxpayers’ losses. The appellate courts applied the economic substance doctrine to even get to the process of counting up profits. And unfortunately, the taxpayers did not attack that in their petitions, evidently for fear of confusing the issue they hoped would attract the attention of the Supreme Court.


Meanwhile, the U.S. district judge in Massachusetts has ruled for a taxpayer in another STARS case, Santander Holdings USA v. United States (D. Mass. 2015). The decision agreed with the taxpayer on every major point: the taxpayer entered the transaction to obtain a reduced price loan, the foreign lender did not “pay” the taxpayer’s taxes, and the taxpayer did not escape any taxes but derived an economic benefit in a deal where it paid taxes on its income. 

If the Supreme Court hears one of the pending cases, we likely will have an answer in this area long before the Santander case is concluded. 

For additional information, call Jack Cummings at 919.862.2302.

This advisory is published by Alston & Bird LLP’s Federal Tax practice area to provide a summary of significant developments to our clients and friends. It is intended to be informational and does not constitute legal advice regarding any specific situation. This material may also be considered attorney advertising under court rules of certain jurisdictions.
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