STARS: Wells Fargo transaction struck down
A structured finance transaction was partly rejected by a US appeals court.
Three other banks that engaged in similar transactions have gone to court to defend the hoped-for tax results in the transactions. All three lost when the cases reached US courts of appeal.
The transaction is called STARS, for structured trust advantaged repackaged securities. It was promoted by KPMG starting in 2001.
Wells Fargo engaged in the transaction with Barclays in 2002. The district court judge who heard the case said the transaction was so complicated that “it almost defies comprehension.”
It had two parts.
Wells Fargo contributed $6.7 billion in income-earning assets to a Delaware trust and appointed a Wells Fargo affiliate that was a UK tax resident as the trustee. This subjected the income earned on the income-producing assets to tax in the United Kingdom. Wells Fargo claimed the UK taxes paid as a foreign tax credit in the United States.
Barclays bought an interest in the trust from Wells Fargo for $1.25 billion. In substance, the purchase was a loan to Wells Fargo. Wells Fargo made payments to Barclays that were essentially interest on the loan. Wells Fargo was required to buy back the trust interest — in effect, repay the loan principal — after five years.
The interest that Barclays held in the trust in theory entitled it to cash distributions of income the trust earned on the income-producing assets. However, in practice, the distributions were paid into a blocked account at Wells Fargo in Barclays’ name. The money was then reinvested in the trust.
This allowed Barclays to deduct the money retained by the trust from its UK taxes as a trading loss. It also received credit against the UK taxes it had to pay on its distributions from the trust for the UK taxes already paid by the trust on the trust’s income.
It made fixed “Bx” payments of roughly $32 million a year to Wells Fargo that were around 47.5% of the UK tax credits received by Barclays, thereby effectively reducing the interest that Wells Fargo had to pay on the loan. Barclays was then able to take further tax deductions in the UK for the Bx payments.
At the end of the day, the transaction was a complicated $1.25 billion loan by Barclays to Wells Fargo structured to produce tax benefits for Barclays that the UK bank shared partly with Wells Fargo to reduce the interest Wells Fargo had to pay on the loan.
British tax authorities alerted the IRS in 2005 that STARS may be an abusive tax shelter.
The IRS put a halt to the transactions in 2007 by issuing regulations, but the regulations did not apply retroactively.
The federal district court that heard the case said that the trust part of the transaction was a sham, but allowed Wells Fargo to deduct the interest it paid on the loan. It disallowed the foreign tax credits claimed by Wells Fargo for the UK taxes paid on the trust income.
The appeals court agreed. It said Wells Fargo had voluntarily subjected itself to taxes in the UK on the trust income. This was not a transaction for which Congress intended to give foreign tax credits, it said. “Wells Fargo artificially generated this tax by engaging in an economically meaningless activity which was specifically designed to create foreign-tax liability.”
Three other banks that went to court to defend their STARS transactions — Bank of New York Mellon, BB&T and Sovereign — also lost in appeals courts for the 1st, 2nd and federal circuits. (For earlier coverage, see “A transaction lacked economic substance” about the BB&T case in the July 2015 NewsWire and “Economic substance” about the Bank of New York Mellon case in the November 2015 NewsWire.)
The latest case is Wells Fargo v. United States. The 8th circuit court of appeals released its decision in late April.