Salem Fin., Inc. v. United States

• Decision Date: 14 May 2015
• Docket Number: No. 2014–5027.,2014–5027.
• Citation: 786 F.3d 932
• Parties: SALEM FINANCIAL, INC., as Successor–in–Interest to Branch Investments LLC, Plaintiff–Appellant v. UNITED STATES, Defendant–Appellee.
• Court: U.S. Court of Appeals — Federal Circuit

786 F.3d 932

SALEM FINANCIAL, INC., as Successor–in–Interest to Branch Investments LLC, Plaintiff–Appellant

v.UNITED STATES, Defendant–Appellee.

No. 2014–5027.

United States Court of Appeals, Federal Circuit.

May 14, 2015.

Rajiv Madan, Skadden, Arps, Slate, Meagher & Flom LLP, Washington, DC, argued for plaintiff-appellant. Also represented by Christopher Paul Bowers, Royce Tidwell, Christopher Patrick Murphy, Nathan P. Wacker ; Matthew James Dowd, Scott M. McCaleb, Wiley Rein, LLP, Washington, DC.

Judith Ann Hagley, Tax Division, United States Department of Justice, Washington, DC, argued for defendant-appellee. Also represented by Tamara W. Ashford, Gilbert Steven Rothenberg, Richard Farber.

Before O'MALLEY, BRYSON, and HUGHES, Circuit Judges.

Opinion

BRYSON, Circuit Judge.

Salem Financial, Inc., a subsidiary of Branch Banking & Trust Corporation (“BB & T”), challenges a final judgment of the Court of Federal Claims denying BB & T's claim for a refund of taxes, interest, and penalties. We affirm in part, reverse in part, and remand for further proceedings.

I

A

BB & T is a financial holding company chartered under the laws of North Carolina. In 2002, BB & T entered into a transaction with Barclays Bank PLC (“Barclays”), which is headquartered in the United Kingdom. The transaction, known as the Structured Trust Advantaged Repackaged Securities transaction (“STARS”), was in effect for nearly five years, from August 1, 2002, through April 5, 2007.

At issue in this case is the U.S. tax treatment of several aspects of BB & T's involvement in the STARS transaction. When the IRS reviewed BB & T's tax treatment of STARS, it disapproved various tax benefits that BB & T had claimed based on the transaction. In particular, the IRS disallowed foreign tax credits in the amount of $498,161,951.00; it disallowed interest deductions in the amount of $74,551,947.40; it imposed taxes on certain payments from Barclays to BB & T in the amount of $84,033,228.20; it disallowed certain transaction cost deductions in the amount of $2,630,125.05; and it imposed penalties in the amount of $112,766,901.80.

STARS was principally developed by Barclays and KPMG LLP, an international accounting firm. The original version of the STARS transaction was marketed to non-bank businesses as a means of enhancing investment yield for large, cash-rich corporations located in the United States by taking advantage of differences between the tax systems in the United States and in the United Kingdom. The central component of this early version of STARS was a trust having a U.K. trustee and paying U.K. taxes. The U.S. participant would then realize an economic benefit by claiming foreign tax credits for the U.K. taxes paid by the trust.

In its original form, STARS failed to attract the non-bank entities Barclays had targeted. Those entities responded that the yield enhancement was not high enough to justify the level of complexity and potential risk in the transaction. With that feedback, Barclays combined the original STARS structure with a loan component in order to attract banks. Barclays and KPMG then promoted the new version of STARS as a “low cost financing” program. The economic benefit to the U.S. participant arising from the foreign tax credits remained the same, however, for both the early version and the later version of STARS.

In November 2001, Barclays representatives contacted the head of BB & T's Tax Department regarding the prospect of entering into a STARS transaction. The parties “discussed in some detail [BB & T's] appetite to do a [foreign tax credit] trade.” Shortly thereafter, BB & T met with KPMG and Barclays. At the time of that meeting, KPMG had participated in the implementation of STARS transactions between Barclays and two other U.S. banks, and BB & T was aware of that fact. It was proposed that BB & T would form a U.K. trust with its U.S.-based income-generating assets, and Barclays would provide a large loan to BB & T. KPMG and Barclays represented that BB & T would obtain foreign tax credits against its U.S. tax obligations for the U.K. taxes paid by the trust and also share in the tax benefits that Barclays would obtain from the U.K. based on its participation in the transaction.

The tax risks of STARS were apparent to BB & T from the outset. Those risks included that BB & T might be denied the full amount of the foreign tax credits on its U.S. taxes and that Barclays might be unable to obtain the expected tax benefits from the U.K. After a lengthy negotiation regarding the allocation of the tax risks, BB & T and Barclays reached an agreement and closed the transaction on August 1, 2002.

On KPMG's recommendation, BB & T engaged Sidley, Austin, Brown & Wood LLP (“Sidley”) as its tax advisor on the STARS transaction. Sidley issued its tax opinion on STARS in April 2003. In addition, BB & T tasked accounting firm PricewaterhouseCoopers (“PwC”), its outside auditor, with evaluating the tax reserve level of STARS.

B

STARS is a complex transaction consisting of many components. The trial court conducted a thorough analysis of the various structures and steps that made up STARS. We summarize below the most salient aspects of the transaction.

STARS consisted of a trust component (“the Trust”) and a loan component (“the Loan”). Although many intermediary entities were created to implement STARS, the real parties in interest at all times were BB & T and Barclays. BB & T created the Trust, to which it contributed approximately $5.755 billion of U.S.-based income-generating assets. The Loan consisted of a payment by Barclays of $1.5 billion in cash to the Trust in return for subscription to three classes of equity interests in the Trust. The Trust, however, remained at all times under BB & T's control, and Barclays was contractually obligated to sell its interests in the Trust back to BB & T for $1.5 billion when the transaction terminated, so the effect of that portion of the transaction was a $1.5 billion Loan from Barclays to BB & T. The interest rate on the Loan was set at a floating rate of approximately one-month LIBOR plus 25 basis points.¹

BB & T appointed a U.K. trustee for the Trust. The trustee's U.K. residence subjected the Trust's income to U.K. taxation. Pursuant to the STARS agreements, BB & T would receive monthly distributions of the income generated from the assets held by the Trust. After setting aside an amount to pay the U.K. taxes and the management fee, the Trust would remit the remaining funds to BB & T. Before doing so, however, the Trust would temporarily place the distributions into the “Barclays Blocked Account” at BB & T, which would then immediately return those funds to the Trust. That circular movement of the Trust distributions generated a substantial tax benefit for Barclays by allowing it to claim a “trading loss deduction” under U.K. law.

BB & T had the Trust use its funds to pay the U.K. tax on the Trust's income. Barclays would then obtain U.K. tax deductions and credits for almost all of the U.K. taxes paid by the Trust based on Barclays' nominal equity interest in the Trust and the circulation of funds through the Barclays Blocked Account.

As part of the STARS transaction, Barclays would make a monthly payment to BB & T, known as the “Bx payment.”

The Bx payment was set to be equal to 51 percent of the U.K. taxes paid by the Trust, which had been paid by BB & T and which resulted in the tax benefits obtained by Barclays. Each month, BB & T's interest obligation under the Loan and Barclays' Bx payment obligation to BB & T were netted against each other. From September 2002 until mid–2005, Barclays, the lender, made net monthly payments to BB & T, the borrower, because the amount of Barclays' Bx payment obligation exceeded the amount of BB & T's interest obligation.

The following example illustrates the cash flows in and out of the Trust based on $100 of Trust income (ignoring fees). The Trust income was subject to U.K. taxation at a 22 percent rate. Therefore, $22 for every $100 of Trust income was set aside for payment of the U.K. taxes, leaving the Trust with $78 after the U.K. tax payment. Because of its nominal equity interest in the Trust, Barclays was also taxed on the Trust income under U.K. law at a corporate tax rate of 30 percent, or $30 for every $100 of Trust income. Barclays, however, was able to claim a $22 U.K. tax credit for the $22 of tax paid by the Trust as an “imputation credit” that partially offset the higher corporate tax imposed on the Trust's distributions. As a result, Barclays effectively paid $8 in U.K. tax.

The Trust distributed the after-tax amount of $78 of Trust income to the Barclays Blocked Account, from which that sum was immediately re-contributed to the Trust. Under U.K. law, Barclays was able to treat the re-contributed $78 as a “trading loss,” thereby claiming a trading loss deduction. At the 30 percent tax rate, that deduction was worth $23.40. Barclays' $8 U.K. tax liability was then completely offset by the $23.40 tax deduction, leaving Barclays with a net tax benefit of $15.40.

In the example, the Bx payment that Barclays paid to BB & T, which was predetermined to be equal to 51 percent of the Trust's U.K. tax payments, would be approximately $11. Barclays would then deduct the $11 Bx payment from its U.K. corporate taxes, which at the 30 percent tax rate yielded another tax benefit worth $3.30. The net benefit to Barclays, for every $100 in Trust income, was thus $7.70, based on U.K. tax credits and deductions (the net tax benefit of $15.40 minus the Bx payment of $11, plus the tax benefit of $3.30 attributable to the deduction for the Bx payment).

For its part, BB & T, having paid the $22 U.K. tax on the Trust income, would claim a foreign tax credit of $22 for the entire amount of the Trust's U.K. taxes. However, having received the $11 Bx payment from Barclays, BB & T would have a net gain of $11.

The U.K. government effectively collected $3.30 in tax for every $100 of...