A key court found economic substance lacking in two transactions in September.

The IRS is free to deny tax benefits claimed in transactions that lack economic substance.

The US appeals court for the 2d circuit — considered one of the most influential by lawyers — found no economic substance in transactions that AIG and the Bank of New York Mellon Corp did more than a decade ago.

Congress has since written into the US tax code that transactions must have economic substance. The appeals court applied a version of the requirement that was developed over many years as common law.

The cases are American Insurance Group v. United States and Bank of New York Company v. Commissioner.

AIG Financial Products entered into six cross-border transactions between 1993 and 1997. The company essentially borrowed from foreign banks at rates below LIBOR and reinvested the funds at rates above LIBOR. In each transaction, AIG set up a special-purpose foreign subsidiary. The foreign lender advanced its funds to AIG in the form of a subscription in the AIG subsidiary for preferred shares. AIG committed to repurchase the preferred shares on a specific future date for the original share price.

AIG took the position for US tax purposes that it was the sole owner of each subsidiary. It claimed foreign taxes paid by each subsidiary as a foreign tax credit in the United States. It deducted the “dividends” paid to each lender as interest.

Meanwhile, each foreign bank treated its preferred shares as an equity investment for tax purposes in its home country and treated the payments to it as tax-exempt dividends rather than taxable interest. This allowed it to charge a lower interest rate on the loan.

AIG said the transactions had substance because they were expected to generate $168.8 million in pre-tax profit. It ignored the foreign and US taxes paid and foreign tax credits in its calculation.

It said in its brief that a court cannot deny it foreign tax credits for foreign taxes that were actually paid.

The appeals court disagreed. It said the economic substance doctrine allows courts to take a “second look” at whether particular uses of tax benefits comply with Congressional purpose.

The court isolated the part of each transaction that generated the foreign tax credits for AIG in the United States and then applied a two-prong test to assess whether that leg of the transaction had substance.

There has to be an objective expectation of profit apart from tax benefits. The court said the foreign taxes paid should be treated as a cost in assessing whether there was a profit to be made, but, at the same time, the foreign tax credits claimed in the United States should be ignored as that is the benefit whose appropriateness the court is testing. Not all transactions have to show an expectation of profit. A profit is not required in cases where the tax benefit is supposed to induce companies to make investments — for example, in low-income housing — that would otherwise be uneconomic absent the tax subsidy.

The other prong is there must be a non-tax business reason for the transaction. The appeals court said that, while there was room for argument, there was enough evidence for the lower court to have decided this in favor of the government.

Turning to the Bank of New York case, the bank 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.

The US Tax Court denied the Bank of New York the foreign tax credits on economic substance grounds, but allowed it to deduct the interest paid on the loan. The appeals court agreed. It said the “circular cash flow demonstrates that Bank of New York, far from risking double taxation, used an extremely convoluted transaction structure to take maximum advantage of US and UK tax benefits.” (For earlier coverage, see the April 2013 Project Finance NewsWire article, A Transaction Lacked Economic Substance.)

The issues may be headed to the US Supreme Court. The US appeals courts are split on the key issues in the cases. BB&T, another unsuccessful bank in a transaction with Barclays like the one done by Bank of New York, asked the Supreme Court in late September to hear its case. (For earlier coverage of the BB&T case, see the July 2015 Project Finance NewsWire article, A Transaction Lacked Economic Substance.)