Economic Substance Doctrine Can Be Applied to Disallow Foreign Tax Credits.

(Parker Tax Publishing October 8, 2015)

The economic substance doctrine applies to transactions involving foreign tax credits and, where economic substance is lacking, foreign tax credits will be denied. The Bank of New York Mellon Corporation v. Comm'r, 2015 PTC 243 (2d Cir. 2015).

On September 9, 2015, the Second Circuit heard appeals in tandem from The Bank of New York Mellon Corporation and American International Group, Inc. (AIG), challenging the disallowance of foreign tax credits associated with certain foreign transactions. The credits were disallowed on the basis that the transactions lacked economic substance. AIG challenged an opinion and order of the U.S. District Court for the Southern District of New York and The Bank of New York Mellon Corporation challenged a judgment of the Tax Court.

Between 1993 and 1997, AIG entered into six crosstransactions with foreign financial institutions through its subsidiary, AIG Financial Products (AIG-FP). Each cross-border transaction began with a foreign affiliate, a special purpose vehicle (SPV), created by AIG to hold and invest funds in a foreign country. Through these cross-border transactions, AIG-FP borrowed funds at economically favorable rates below LIBOR (i.e., the London Interbank Offered Rate, the benchmark rate that many banks charge each other for short-term loans) and invested the funds at rates above LIBOR, ostensibly to make a profit.

The transactions effectively reduced AIGtotal tax bill. It also allowed the foreign banks to limit their tax liability, inducing them to accept lower return rates from AIG. Thus, AIG effectively converted certain interest expenses it otherwise would have paid to the foreign banks into foreign tax payments for which it claimed foreign tax credits that it could use in turn to offset unrelated income and reduce its total U.S. tax bill.

AIG claimed that the crosstransactions had economic substance because they were expected to generate a preprofit of at least $168 million for AIG over the life of the transactions. In calculating preprofit, AIG ignored: (1) the foreign tax paid by the SPV; (2) the U.S. tax paid by AIG on the SPVinvestment income; and (3) the value of the foreign tax credits claimed by AIG.

The Bank of New York Mellon Corp. case involved alleged tax deficiencies of approximately $215 million. The Tax Court held a trial on the economic substance of the Structured Trust Advantaged Repackaged Securities (STARS) loan product purchased by Bank of New York Mellon (BNY). The Tax Court held: (1) the effect of foreign taxes must be considered in the preanalysis of economic substance; and (2) STARS lacked economic substance, and thus BNY could not claim foreign tax credits associated with STARS. The Tax Court further held that certain income from STARS was includible in BNYtaxable income and BNY was not entitled to deduct interest expenses associated with STARS, but reversed both rulings on reconsideration.

The Second Circuit affirmed the decisions of the district court and the Tax Court and held that the economic substance doctrine applies to the foreign tax credit regime generally, and that both the district court and Tax Court properly determined the tax implications of the crossand STARS transactions. The Court rejected the contention that foreign tax credits, by their nature, are not reviewable for economic substance. The purpose of the economic substance doctrine, the court said, is to ensure that a taxpayeruse of a tax benefit complies with Congresspurpose in creating that benefit. Accordingly, the court concluded that the economic substance doctrine can be applied to disallow a claim for foreign tax credits.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700. (Staff Editor Parker Tax Publishing)

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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