Recent case of interest reiterating the requirement for a STARS (“Structured Trust Advantaged Repackaged Securities”) loan to be separate and distinct from a STARS trust under the economic substance doctrine:
The United States Court of Federal Claims recently published an opinion denying a financial institution’s claim for a tax refund after determining that the STARS transaction in question was actually an abusive tax shelter. See, Salem Financial, Inc. v. United States, –Fed.Cl.–, No. 10-192T, 2014 WL 47541 (Jan. 7, 2014).
Plaintiff, Salem Financial, Inc. a subsidiary of BB & T Corporation, created a STARS transaction that was in effect from 2002 through 2007. STARS were developed to generate tax benefits to be shared among the transaction’s participants, which generally consists of a trust and a loan. The trust at issue in this matter contained approximately $6 billion in revenue-producing assets. The administrator of the trust was based in the United Kingdom, so the monthly revenue from the trust assets was taxable in the U.K. rather than in the U.S. The proceeds were received from the trust and contributed back to the trust in a circular flow of funds. The subsequent transfer of revenues out of the U.K. generated U.K. tax credits, which were split between Plaintiff and Barclays Bank, who developed the trust. In an effort to give the transaction the appearance of having a legitimate business purpose, the STARS transaction included a $1.5 billion loan from Barclays to Plaintiff. On a monthly basis, Barclays made a payment to Plaintiff representing Plaintiff’s share of the tax credits, which had the effect of reducing the interest cost of the loan.
Plaintiff claimed it was entitled to claim $74,551,947.40 in deductions for interest expenses on the loan. In reviewing Plaintiff’s claim, the Court analyzed the STARS transaction according to the economic substance doctrine, which prevents the recognition of tax benefits from abusive tax shelters. Under the economic substance doctrine, a taxpayer bears the burden of demonstrating that a given transaction carries both (1) the objective possibility of realizing a pre-tax profit (objective economic substance), and (2) a non-tax business purpose (subjective economic substance).
While the first prong is supposed to be objective, it hardly appears to be the case. The pre-tax profit prong of the economic substance test requires an objective analysis of whether a prudent investor had a reasonable possibility of making a profit from the transaction apart from tax considerations. The Court found that no prudent investor would view the loan transaction as having a reasonable possibility of making a pre-tax profit. More specifically, the Court was troubled because the payment on the loan was generated by the circular cash flows designed for tax purposes. In addition, the cost of borrowing on the loan was determined to be the London Interbank Offered Rate plus twenty-five basis points. The Court concluded that clearly this was significantly higher than rates on comparable sources of funds available to Plaintiff. While it’s debatable as to whether this is actually objective, the Court easily concluded that no reasonable commercial bank would engage in such a transaction when it had less expensive and less complex funding sources available.
The non-tax business purpose prong of the economic substance test focuses on whether the taxpayer’s sole subjective motivation is tax avoidance. The Court found that the loan lacked any non-tax business purpose and served only to camouflage the true nature of the tax avoidance scheme. Furthermore, the Court found that the loan and trust were artificially linked to enable Plaintiff to deduct U.S. tax benefits generated by the trust structure from the cost of the loan, thereby making the loan appear to be low-cost funding. Whether viewed separately or together as one integrated STARS transaction, the Court found that the entire transaction must be disregarded for lack of economic substance.
While not controlling as to the Court of Federal Claims, a recent Tax Court decision ruled that even with a relatively expensive loan, a STARS transaction could claim deductions on the interest if the loan was used for economically substantive activity. This is true even if the remainder of the transaction was found to lack economic substance as required by the economic substance doctrine. However, the key difference between the STARS transaction at hand and the previous Tax Court decision is whether the loan and trust are “separate and distinct”. Technically, the loan and trust were two discrete components, but the Court found that the Loan component was essential to “carry out” the STARS structure and was necessary to successfully market the STARS transaction to U.S. companies such as Plaintiff. The Court found that Plaintiff entered into the loan due to the need to hide that the trust structure was a sham. In other words, the loan was necessary to the remainder of the STARS transaction, and therefore, the loan was not separate and distinct from the remainder of the transaction.
The question remains, when exactly is the loan “separate and distinct”? The Court appears to indicate that the decision turns on the availability of the loan proceeds. For example, if the proceeds from the loan were available to Plaintiff for use in its banking business, regardless of the expense, then the loan and trust are “separate and distinct”. Therefore, the loan would have an economic substance because there is a non-tax business purpose for the loan.
In summary, the opinion seems to shed a bit of light on how a STARS loan and trust should be characterized or used in order to assert a claim for interest expense deductions. The STARS loan must be “separate and distinct” from the rest of the transaction. The loan should not be used to finance, secure or carry out the STARS structure. Finally, the proceeds from the loan should be available for use in the course of regular business. Such characterization and use will help in demonstrating that the STARS transaction in question complies with the economic substance doctrine in order to achieve the intended tax benefits generated by the STARS transaction.
No information in this article is intended to constitute legal advice. For specific legal advice, please contact an attorney.
If you have any questions or would like more information about Structured Trust Advantaged Repackaged Securities (“STARS”) and the Economic Substance Doctrine, please contact Eric Mettenbrink at 713.220.9141 or emettenbrink@hirschwest.com.