District Court Allows Foreign Tax Credit in STARS Transaction
(Parker Tax Publishing November 2013)

A taxpayer who engaged in a STARS transaction, a transaction that other courts have held lacked economic substance, was entitled to a foreign tax credit. Santander Holdings USA, Inc. & Subs. v. U.S., 2013 PTC 333 (D. Mass. 10/17/13).

From 2003 through 2005, Santander Holdings USA, Inc. was known as Sovereign Bancorp, Inc. Sovereign sued to recover approximately $234 million in federal income taxes, penalties, and interest that it claimed were improperly assessed and collected by the IRS for tax years 2003 - 2005 as a result of the IRS's disallowance of foreign tax credits claimed for those years. The IRS defended the disallowance on the ground that the transaction in which Sovereign incurred and paid the foreign taxes against which the credit was taken was a sham and lacked economic substance. The case centered on a Structured Trust Advantaged Repackaged Securities transaction, otherwise known as a STARS transaction, and also involved Barclays Bank PLC, a U.K. bank, and its advisor, KPMG.

The STARS transaction was designed to give Barclays substantial benefits under U.K. tax laws, in light of which Barclays could and would offer to lend funds to U.S. banks at a lower cost than otherwise might be available to them. The banks could relend the money in their normal banking operations, using the lower cost either to obtain a competitive advantage or to increase their marginal return on lending or both. In the transaction, Sovereign created a trust to which it contributed $6.7 billion of income-generating assets. The trustee of the trust was purposely made a U.K. resident, causing the trust's income to be subject to U.K. income tax at a rate of 22 percent. The trust income was also subject to U.S. income tax and was attributed to Sovereign, but with a credit available for the amount paid in U.K. income taxes. Sovereign paid U.K. taxes and then claimed credits for the amounts paid in calculating its U.S. income tax liability for the tax years in question. The transaction included a number of contrived structures and steps that, each viewed in isolation, would make little or no sense. In the context of the entire transaction, however, it was crucial to Barclays' obtaining favorable tax treatment under U.K. law, which gave it the ability to lower its effective lending rate to a U.S. bank. The result of the STARS transaction for Barclays was a net tax gain, which it was able to use to reduce other U.K. tax liabilities that it owed.

One feature of the loan arrangements was what that Barclays would make a payment to Sovereign calculated at approximately one-half of the amount Sovereign paid in taxes to the U.K. on the income earned by the trust. While in the intricacies of the transaction it was actually a monthly credit to Sovereign figured into its interest costs, the IRS characterized it as a rebate. According to the IRS, the transaction lacked economic substance because the Barclays payment was effectively a rebate of taxes originating from the U.K. tax authorities. The IRS's theory was that Barclays was only able to make the payment because of the tax credits it had received from the U.K.

Under Reg. Sec. 1.901-2(e)(2), an amount is not a tax paid to a foreign country, and thus is not eligible for the foreign tax credit, to the extent it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. Further, under Code Sec. 901(i) and Reg. Sec. 1.901-2(e)(3), an amount of foreign income tax is not an amount of income tax paid or accrued by a taxpayer to a foreign country to the extent (1) the amount is used, directly or indirectly, by the foreign country imposing the tax to provide a subsidy by any means to the taxpayer, to a related person, to any party to the transaction, or to any party to a related transaction; and (2) the subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of the tax.

A district court rejected the IRS argument as wholly unconvincing. The court noted that Code Sec. 901(i) and Reg. Sec. 1.901-2(e)(2) explicitly provide when a foreign tax may be considered rebated by the taxing authority and when a taxpayer may be considered to have received a subsidy (i.e., a rebate being a type of subsidy) from a foreign source to pay its foreign taxes. Since the IRS could point to no governing or precedential legal authority that supported treating the private payment between two banks as a payment from the U.K. treasury, the court allowed the foreign tax credit.

OBSERVATION: In Santander Holdings, the court distinguished its holding from the holdings reached by the Court of Federal Claims and the Tax Court in Salem Financial, Inc. v. U.S., 2013 PTC 282 (Fed. Cl. 2013) and Bank of N.Y. Mellon Corp. v. Comm'r, 140 T.C. No. 2 (2013). In both of those decisions, the courts held that the STARS transactions in which the taxpayers engaged lacked economic substance and, thus, denied the foreign tax credit to the taxpayers. The district court said that those decisions dealt with the question of whether the payment by the other bank to the trust in which the taxpayers had an ownership interest was in substance a tax effect as a matter of fact, rather than as a matter of law. By looking at the question as a matter of law, the district court in Santander Holdings came to a different conclusion than the Court of Federal Claims and the Tax Court.

For a discussion of the foreign tax credit and situations where it is not allowed, see Parkers Tax ¶101,915. (Parker Tax Publishing Staff Writers)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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