Bank of N.Y. Mellon Corp. v. Comm'r

• Decision Date: 09 September 2015
• Docket Number: 14–765–cv.,14–1394–agXAP,Nos. 14–704–agL,s. 14–704–agL
• Citation: 801 F.3d 104
• Parties: The BANK OF NEW YORK MELLON CORPORATION, as Successor in Interest to The Bank of New York Company, Inc., Petitioner–Appellant–Cross–Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee–Cross–Appellant. American International Group, Inc., Plaintiff–Appellant, v. United States of America, Defendant–Appellee.
• Court: U.S. Court of Appeals — Second Circuit

801 F.3d 104

The BANK OF NEW YORK MELLON CORPORATION, as Successor in Interest to The Bank of New York Company, Inc., Petitioner–Appellant–Cross–Appellee

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee–Cross–Appellant.

American International Group, Inc., Plaintiff–Appellant

v.United States of America, Defendant–Appellee.

Nos. 14–704–agL

14–1394–agXAP

14–765–cv.

United States Court of Appeals, Second Circuit.

Argued: May 18, 2015.

Decided: Sept. 9, 2015.

Seth P. Waxman (Catherine M.A. Carroll, Weili J. Shaw, Jonathan A. Bressler, William J. Perlstein, Alan E. Schoenfeld, Roger M. Ritt, Richard W. Giuliani, on the brief), Wilmer Cutler Pickering Hale and Dorr LLP, Washington, DC, New York, NY, and Boston, MA, for Petitioner–Appellant–Cross–Appellee Bank of New York Mellon Corporation.

Judith A. Hagley, Tax Division, Department of Justice (Gilbert S. Rothenberg, Richard Farber, Tax Division, Department of Justice, on the brief), for Tamara W. Ashford, Acting Assistant Attorney General, Washington, DC, for Respondent–Appellee–Cross–Appellant Commissioner of Internal Revenue.

David Boies (Robin A. Henry, Edward J. Normand, on the brief), Boies, Schiller & Flexner LLP, Armonk, New York, and Thomas A. Cullinan, Jerome B. Libin, Daniel H. Schlueter, Sutherland Asbill & Brennan LLP, Atlanta, GA, and Washington, DC, for Plaintiff–Appellant American International Group, Inc.

Joseph N. Cordaro, Assistant United States Attorney (James Nicholas Boeving, Benjamin H. Torrance, Assistant United States Attorneys, on the brief), for Preet Bharara, United States Attorney for the Southern District of New York, New York, NY, for Defendant–Appellee United States of America.

Scott P. Martin, Geoffrey C. Weien, Gibson, Dunn & Crutcher LLP, Washington, DC, and Kate Comerford Todd, Steven P. Lehotsky, U.S. Chamber Litigation Center, Inc., Washington, DC, for Amicus Curiae United States Chamber of Commerce.

Martin S. Kaufman, Larchmont, NY, for Amicus Curiae Atlantic Legal Foundation.

Before: CABRANES, RAGGI, and CHIN, Circuit Judges.

Opinion

CHIN, Circuit Judge:

These appeals and cross-appeal, heard in tandem, challenge an opinion and order of the United States District Court for the Southern District of New York (Stanton, J. ) and a judgment of the United States Tax Court (Kroupa, J. ) applying the “economic substance doctrine” to transactions involving foreign tax credits. In both cases, the taxpayers claim they are entitled to tax credits associated with foreign transactions that the government disallowed because it contends the transactions lacked economic substance.

In American International Group., Inc. v. United States, in which American International Group (“AIG”) seeks a tax refund of $306.1 million, the district court held that: 1) the economic substance doctrine applies to the foreign tax credit regime; and 2) the pre-tax benefit that AIG gained from its “cross-border” transactions is to be calculated by taking into account foreign taxes. Accordingly, the district court denied AIG's motion for partial summary judgment. It certified the matter for interlocutory appeal.

In Bank of New York Mellon Corp. v. Commissioner, which involves alleged tax deficiencies of some $215 million, the Tax Court held a three-week bench trial on the economic substance of the Structured Trust Advantaged Repackaged Securities loan product (“STARS”) purchased by Bank of New York Mellon (“BNY”). The Tax Court held: 1) the effect of foreign taxes is to be considered in the pre-tax analysis 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 BNY's taxable income and BNY was not entitled to deduct interest expenses associated with STARS, but reversed both rulings on reconsideration.

We hold 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 cross-border and STARS transactions. Accordingly, we affirm.

STATEMENT OF THE CASE

A. The Foreign Tax Credit Regime

Various provisions of the Internal Revenue Code (the “Code”) seek “to mitigate the evil of double taxation.” Burnet v. Chi. Portrait Co., 285 U.S. 1, 7, 52 S.Ct. 275, 76 L.Ed. 587 (1932). The Code taxes all income of U.S. taxpayers earned worldwide. 26 U.S.C. § 61(a). Because this can result in double taxation of a U.S. taxpayer's income earned abroad—by the country in which it was earned as well as the United States—Congress crafted the “foreign tax credit” regime.

First established by the Revenue Act of 1918, the foreign tax credit regime was intended to facilitate business abroad and foreign trade. See 56 Cong. Rec. app. 677 (1918) (statement of Rep. Kitchin) (“We would discourage men from going out after commerce and business in different countries ... if we maintained this double taxation.”). Under the regime, when a U.S. taxpayer pays income tax to another country due to its business activities in that country, the taxpayer can claim a dollar-for-dollar credit against its U.S. tax liability for the foreign taxes paid. 26 U.S.C. §§ 901 –909. This “foreign tax credit” then mitigates double taxation by offsetting the taxpayer's U.S. taxable income and reducing its overall tax bill. The foreign tax credit regime does not, however, require a taxpayer “to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax.” 26 C.F.R. § 1.901–2(e)(5)(i).

As relevant to the instant cases, the Code deems taxes paid by foreign subsidiaries to be paid by their U.S. parent companies. 26 U.S.C. §§ 902, 960. Thus, in a given tax year, a U.S. corporation can claim a “foreign tax credit” in the same amount as the foreign taxes paid by its foreign subsidiary, reducing its total U.S. taxable income.

“Entitlement to foreign tax credits[, however,] is predicated on a valid transaction.” 12 Mertens Law of Federal Income Taxation § 45D:62. To be “valid” and not just a “sham,” a transaction must involve more than just tax benefits: it must have independent economic substance. See DeMartino v. Comm'r, 862 F.2d 400, 406 (2d Cir.1988) (“A transaction is a sham if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions.”). Accordingly, as we discuss below, a court can hold that a taxpayer is not entitled to certain deductions or other tax benefits where it finds that the underlying transaction lacks “economic substance” beyond its tax benefits.

B. American International Group, Inc. v. United States

1. The Facts

As AIG acknowledges, the facts relevant to this appeal are largely undisputed.¹ To the extent that there is dispute, we construe the facts in the light most favorable to the non-moving party, the government:

Between 1993 and 1997, AIG entered into six cross-border transactions with foreign financial institutions through its subsidiary, AIG Financial Products (“AIG–FP”).² Through these transactions, AIG–FP borrowed funds at economically favorable rates below LIBOR and invested the funds at rates above LIBOR, ostensibly to make a profit.³

Each cross-border transaction operated as follows. First, AIG–FP created and funded a foreign affiliate—a special purpose vehicle (“SPV”)—to hold and invest funds in a foreign country. Next, AIG–FP sold the SPV's preferred shares to a foreign lender bank and committed to repurchase the preferred shares on a specific future date at the original sale price. The SPV's capital was thus primarily comprised of the funds the foreign bank paid for the preferred stock, as well as a smaller contribution from AIG. The SPV then used this capital to purchase investments, earning income for which the SPV paid taxes to the relevant foreign authority. The SPV then paid most of the net proceeds of this investment income to the foreign bank as dividends.

For U.S. tax purposes, AIG claimed that it owned all of the shares of the SPV and thus treated the foreign bank's funds for the purchase of the preferred shares as a loan. AIG then deducted the dividends paid by the SPV to the foreign banks as interest expense. AIG also claimed foreign tax credits for the full amount of the foreign taxes paid by each SPV on the pre- dividend investment income. Accordingly, on its 1997 U.S. tax return, AIG reported total gross income from the cross-border transactions of $128.2 million from which it deducted $71.9 million in interest expenses, for a net taxable income of $56.3 million. Based on the corporate tax rate of 35%, AIG owed $19.7 million in taxes on the cross-border transactions. But AIG also claimed $48.2 million in foreign tax credits for the foreign taxes paid by the SPVs on total income, which it then used to offset U.S. tax not only on its $19.7 million U.S. tax obligation for the cross-border transaction, but also on some $28.5 million in unrelated income.

At the same time, each foreign bank reported to the relevant foreign revenue authority that it owned the preferred stock as an equity investment in the SPV. As a result, for foreign tax purposes, the SPV was treated as the foreign bank's corporate subsidiary. Accordingly, instead of treating the SPV's distribution to the foreign bank as taxable interest on a loan to AIG, the foreign bank claimed the payments as tax-exempt dividends on which it paid little, if any, tax. Instead, the SPV paid tax on the SPV's income to the relevant foreign authorities. The foreign bank then shared these tax benefits with AIG–FP by accepting a lower dividend rate than it would have otherwise demanded if its investment income were taxable.

This arrangement effectively reduced AIG's total 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...