Here, we often discuss ways to plan for tax recognition events, but on a smaller scale – planning concerning your house, your IRA, your other plans, bank account, your small business, etc. At the core of all this is the economic substance doctrine. The same rules apply to the bigger players too.
The New York Times reported Friday that BB&T Corp. lost a case in the U.S. Court of Federal Claims. According to the story, the judge ruled that a financial product sold by a unit of BB&T was “an economically meaningless tax shelter,” and that BB&T was not entitled to a $772 million refund from the IRS.
The financial product in question was a STARS transaction, or a structured trust advantaged repackaged securities transaction. As The New York Times reported, the purpose of the transaction was to scoop up foreign tax credits for clients. Why?
“Foreign tax credits are awarded to U.S. companies by the IRS to ensure that they are not taxed twice on the same profits by the U.S. government and by a foreign government. BB&T had been fighting for a $772 million refund from the IRS.”
In February, Bloomberg reported that BNY Mellon encountered legal troubles when it attempted to claim nearly $200 million in tax credits from a similar transaction. In that case, the judge described the STARS transactions as circular flows with no economic substance.
The article about BNY Mellon described the transaction thus:
“The 2001 transaction purported to give BNY Mellon below market rate financing from Barclays and involved the transfer of income producing assets from the U.S. bank to a trust with a U.K. trustee and subject to U.K. income tax, according to Kroupa’s ruling.
“The STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies,” Kroupa wrote. “The U.K. taxes at issue did not arise from any substantive foreign activity. Indeed, they were produced through pre-arranged circular flows from assets held, controlled and managed with the United States. We conclude that Congress did not intend to provide foreign tax credits for transactions such as STARS.””
How do they work? ProPublica – in conjunction with the Financial Times – did an excellent piece describing the transactions in 2011; their summary is here.
“A U.S. bank transfers several billion dollars in income-producing assets to a trust and sets up a subsidiary as trustee in Britain. The bank sells shares in the trust to Barclays but promises to buy them back after a set number of years.
Barclays agrees to provide financing to the U.S. bank for less than the bank’s normal cost of credit, and it routes the money through the trust.
The banks say this structure at its core is simply a low-cost, secured loan. But the IRS says STARS went too far, creating a circular set of transactions that are principally designed to generate artificial tax benefits.
The U.S. bank’s trustee pays British tax on the trust earnings and claims a corresponding U.S. tax credit. Barclays pays some tax as well, but the arrangement also allows the U.K. bank an even larger tax benefit.
That’s because Barclays’ shares give it rights to nearly all the trust income, which the British bank is required to immediately reinvest in the trust. Barclays can deduct this reinvestment as an expense, reducing its U.K. taxes.
Barclays used part of the tax savings to discount the U.S. banks’ borrowing costs and kept the rest. In court filings, BB&T calls this discount an “offset,” while government lawyers call it a “kickback” from Barclays. When the deal expires, Barclays is repaid in exchange for the trust shares”
The IRS legal analysis can be found here.
So how does this tie into anything that the average person is ever going to use?
Well, you’re probably not ever going to need a STARS transaction. Don’t worry. I won’t either. However, at the heart of how the IRS and courts view these transactions is the economic substance doctrine. Essentially, the IRS will approve of a transaction if it has an economic purpose other than the reduction or mitigation of tax liability. The economic substance doctrine is codified in Section 7701 of the Internal Revenue Code (the “Code”). It states thus:
“Under section 7701(o), a transaction is treated as having economic substance only if it passes a conjunctive, two prong test. The test requires that (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position and; (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.”
The doctrine was amended in 2010 to be more restrictive and an internal IRS memo concerning the new provisions can be found here.
The takeaway is that in estate planning or tax planning – or any attempt to limit liability – the mere limitation of liability will provide minimal, if any, protection. It must be incidental to something that the government or society at large values as a matter of policy. The reduction in liability – in this case, taxes – must be incidental.
Estate Law in Texas 