A TRANSACTION LACKED ECONOMIC SUBSTANCE, a US appeals court said in May, but the court set the transaction aside only in part.

BB&T Bank did a STARS transaction with Barclays in 2002 that was supposed to generate large foreign tax credits and interest deductions for BB&T. STARS stands for “Structured Trust Advantaged Repackaged Securities.” The transaction was a “tax product” being marketed 15 years ago by KPMG.

The IRS disallowed foreign tax credits of $498.2 million and interest deductions of $74.6 million, imposed taxes of $84 million on cash payments that BB&T received from Barclays, disallowed deductions for $2.6 million in transaction costs, and imposed penalties of $112.8 million.

A lower federal court agreed with the IRS.

The US appeals court to which BB&T took the appeal described the deal, in a notable understatement, as a “complex transaction.”

BB&T put $5.755 billion in income-generating US assets it owned into a trust and appointed a UK trustee, thereby subjecting the income generated by the assets to income taxes in the United Kingdom.

Barclays paid BB&T $1.5 billion for equity interests in the trust. The payment was in substance a $1.5 billion loan to BB&T because Barclays was contractually obligated to sell its trust interests back to BB&T whenever the transaction terminated for $1.5 billion plus a floating return of the one-month LIBOR yield plus 25 basis points. Either party could terminate the transaction at any time with 30 days’ notice.

The cash generated by the assets was distributed to BB&T after subtracting UK income taxes and management fees to the trustee. However, the distributions ran through a “Barclays blocked account” at BB&T and then back to the trust for distribution to BB&T. This circular motion generated deductions for trading loses for Barclays on its UK tax return.

Barclays was also able to claim tax credits in the UK for the UK income taxes paid by the trust on account of its equity position in the trust.

Barclays made monthly “Bx payments” to BB&T for a share of its tax savings. The payments were calculated as 51% of the UK taxes paid by the trust. Each month, the Bx payment was netted against the interest BB&T owed Barclays and only the net amount paid. Each month, Barclays made net payments to BB&T.

A look at numbers will help make things clearer.

Assume the trust earned income of $100. It paid $22 in UK taxes on the income, leaving $78 for distribution. Barclays was subject separately to tax on the income at a 30% rate as a trust beneficiary, but given an “imputation credit” for the $22 already paid by the trust, for a net tax to Barclays of $8.

The trust distributed the $78 left at the trust level to BB&T after first running the money through the Barclays blocked account to give Barclays a tax deduction in the UK for $78 that, at a 30% UK rate, yielded it tax savings of $23.40. The $8 in tax Barclays had to pay was more than offset by this deduction, giving Barclays a net tax savings of $15.40.

The Bx payment by Barclays to BB&T of 51% of the UK taxes at the trust level is $11. Barclays could deduct the $11 against its UK taxes, giving it another $3.30 in tax savings.

The net benefit to Barclays, after factoring in the $11 it had to pay BB&T, was $7.70 for each $100 in earnings.

Meanwhile, BB&T claimed a foreign tax credit in the United States for the $22 in UK taxes paid at the trust level, and it also had interest deductions.

BB&T anticipated making $44 million a year on the deal.

KPMG initially approached the BB&T tax director about the deal in November 2001. The transaction closed in August 2002. Sidley issued a tax opinion in April 2003. PwC advised BB&T on how large a tax reserve it should establish on account of the deal.

The IRS published proposed regulations in March 2007 to prohibit “highly-engineered transactions where the US taxpayer benefits by intentionally subjecting itself to foreign tax.” Six days later, BB&T terminated the transaction.

The US appeals court said the trust portion of the deal lacked economic substance under general tax principles. (Congress wrote a version of the economic substance doctrine into the US tax code that applies after the tax years at issue.) However, the court said the loan was real.

Therefore, it denied the foreign tax credits BB&T claimed, but allowed the interest deductions. It also said BB&T had to report the Bx payments as income.

The trust, the court said, was “a contrived transaction performing no economic of business function other than to generate tax benefits.”

The lower court had also denied the loan because it said the loan served no purpose but to “camouflage” the tax deal and, stripped of the tax deal, BB&T paid an above-market interest rate on the loan. However, the appeals court said the loan still led to a change in the economic position of BB&T. BB&T had unrestricted access to $1.5 billion and paid Barclays for use of the money.

The last issue in the case was the penalties.

It is a defense to accuracy-related penalties if the taxpayer had reasonable cause for its position and acted in good faith. BB&T pointed to the tax opinion it had from Sidley that the transaction worked. The lower court said Sidley had an inherent conflict of interest, making reliance on the opinion unreasonable, and the appeals court said this conclusion was not “clearly erroneous,” the standard for appeals court review. Sidley had worked with KPMG to develop the structure. KPMG then recommended Sidley to clients using the structure. Sidley sent BB&T a redacted tax opinion about the transaction when it was first engaged, a circumstance, the court said, that “should have raised a red flag that Sidley was not a truly ‘independent’ advisor” since it had written the opinion on the transaction “before it even started exploring the specific circumstances of the transaction for the client.”

PwC did not opine, but ultimately arrived at a “less than should” level of comfort that the IRS would accept the transaction.

The case is Salem Financial, Inc. v. United States. The case was heard in the US appeals court for the federal circuit. The decision is the first to address STARS deals at the appeals court level. Oral arguments in two other STARS cases involving AIG and Bank of New York were heard by the US appeals court for the second circuit in May. Decisions in the cases are expected later this year.

The IRS warned in October 2014 that it remains free to pick apart transactions with more than one leg to deny tax benefits on any leg that is tax motivated while allowing the rest of the transaction to stand. The IRS announcement was in Notice 2014-58.

Keith Martin in Washington