A transaction lacked economic substance
A transaction lacked economic substance, the US Tax Court said.
The Bank of New York borrowed $1.5 billion from Barclays at LIBOR plus 20 basis points in late 2001. The Bank of New York booked the loan through a subsidiary in the Cayman Islands. However, the loan was set up as a transaction run on paper through a trust in the United Kingdom with an elaborate series of agreements a number of which involved circled cash. The main reason for interposing the trust and for some of the arrangements surrounding the trust was to trigger taxes in the United Kingdom on collateral held in a Delaware limited liability company that was a subsidiary of the trust over the term of the loan, which was expected to run through 2006, but to allow the Bank of New York to claim foreign tax credits for them in the United States. Barclays received tax benefits from the arrangement in the United Kingdom and shared half the benefit with the Bank of New York in the form of a reduced interest rate on the loan. The Bank of New York indemnified Barclays against the potential loss of half the UK tax benefits. Absent the tax benefits, the interest rate on the loan would have been LIBOR plus 30 basis points.
KPMG and the Barclays tax department pitched the transaction to the Bank of New York and other banks. They called the structure a “structured trust advantaged repackaged securities” transaction, or STARS for short.
The US Tax Court declined to evaluate the transaction as a whole as a loan with a legitimate business purpose for borrowing at a reduced interest rate, and instead looked at the efforts to generate foreign tax credits for use in the United States as a separate transaction. That separate transaction had no business purpose, the court said.
Even if the transaction were reviewed as an integrated whole, the court said, the loan was not low cost because the high transaction costs plus the interest paid exceeded the cost of borrowing from Barclays directly.
The court declined to let Bank of New York claim foreign tax credits for any UK taxes it actually paid. It said Congress authorized such credits to neutralize US taxes as a factor in deciding where to conduct real business activities. There was no real foreign activity here, but rather a pre-arranged circular cash flow from collateral held, controlled and managed in the United States. The Bank of New York contributed the $7.86 billion in assets to the trust and the Delaware limited liability company that was a subsidiary of the trust that served as the collateral for the loan and provided cash flow with which to repay the loan.
The case is Bank of New York Mellon Corp. v. Commissioner. The court released its decision in the case in February. B. John Williams, a former IRS chief counsel, argued the case for the bank.