140 T.C. No. 2



                     UNITED STATES TAX COURT



BANK OF NEW YORK MELLON CORPORATION, AS SUCCESSOR IN
INTEREST TO THE BANK OF NEW YORK COMPANY, INC., Petitioner
     v. COMMISSIONER OF INTERNAL REVENUE, Respondent



  Docket No. 26683-09.                          Filed February 11, 2013.



         B and its subsidiaries are an affiliated group (Ps). Ps engaged in
  a Structured Trust Advantaged Repackaged Securities transaction
  (STARS transaction). The STARS transaction provided Ps with
  purportedly below market cost financing from a U.K. bank. As part of
  the STARS transaction, Ps transferred income-producing assets to a
  trust with a U.K. trustee and subject to U.K. tax on its income.

         Ps claimed foreign tax credits and expense deductions on its
  2001 and 2002 Federal consolidated returns in connection with the
  STARS transaction. Ps also reported income from the assets
  transferred to the trust as foreign source on the consolidated returns. R
  determined that the STARS transaction lacked economic substance and
  consequently disallowed the foreign tax credits, the expense deductions
  and the reporting of the asset income as foreign source. Ps contend
  that the STARS transaction had economic substance and that Congress
  intended the foreign tax credit to apply to transactions like the STARS
  transaction.
                                          -2-

            Held: The STARS transaction lacked economic substance and is
      disregarded for Federal tax purposes.

            Held, further, because the STARS transaction lacked economic
      substance, Ps are not entitled to the claimed foreign tax credits, the
      claimed expense deductions or the foreign-source income treatment.



      B. John Williams, Jr., Alan J.J. Swirski, Julia M. Kazaks, Cary D. Pugh,

Andrew J. McLean, Daniel C. Davis, Melissa R. Middleton, Shira M. Helstrom,

Brendan T. O’Dell, Bryon Christensen,1 John Marston, Manoj Viswanathan, Ilana

Yergin, Daniel Davis, and Kristin R. Keeling, for petitioner.

      Jill A. Frisch, Curt M. Rubin, Anne O’Brien Hintermeister, Matthew J. Avon,

Justin L. Campolieta, and Michael A. Sienkiewicz, for respondent.



      KROUPA, Judge: Respondent determined deficiencies in petitioner’s

Federal income tax of $100 million2 and $115 million for 2001 and 2002 (years at

issue), respectively. There are three issues for decision. The first issue is whether




      1
       Bryon Christensen, John Marston, Manoj Viswanathan, Ilana Yergin, Daniel
Davis and Kristin R. Keeling all withdrew as counsel after trial.
      2
       All monetary amounts have been rounded to the nearest million unless
otherwise indicated.
                                          -3-

petitioner is entitled to foreign tax credits under section 9013 claimed in connection

with a Structured Trust Advantaged Repackaged Securities transaction (STARS

transaction or STARS). We hold that petitioner is not because the STARS

transaction lacked economic substance. The second issue is whether petitioner is

entitled to deduct certain expenses incurred in furtherance of the STARS

transaction. We hold petitioner is not for the same reason. The final issue is

whether income attributed to a trust with a U.K. trustee used to effect the STARS

transaction is U.S. source income rather than foreign source income. We hold that

the income is U.S. source income.4

                                FINDINGS OF FACT

I. Background

      Petitioner is a Delaware corporation that maintained its principal place of

business in New York, New York, when it filed the petition. Petitioner succeeded

to the tax liabilities of The Bank of New York Company, Inc. (BNY Parent) when

Mellon Financial Corporation merged with BNY Parent in 2007. BNY Parent was

      3
        All section references are to the Internal Revenue Code (Code) for the years
at issue, unless otherwise indicated.
      4
       There is also a question of whether respondent properly adjusted interest
expenses allocated to the foreign source income. We need not address this issue
because of our holding that the trust income reported as foreign source income is
U.S. source income.
                                         -4-

the common parent of an “affiliated group” (as that term is defined in section

1504(a)) of corporations that filed consolidated U.S. Federal income tax returns on

an accrual and calendar year basis. The Bank of New York (BNY) was a wholly

owned subsidiary of BNY Parent. BNY was in the banking business with

worldwide banking operations. Its business activities included taking in deposits,

borrowing money and investing in loans and securities.

      The affiliated group through BNY entered into the STARS transaction in

2001 with Barclays Bank, PLC (Barclays), a global financial services company

headquartered in London, United Kingdom. The STARS transaction generated

approximately $199 million in foreign tax credits for the combined years at issue.

II. Introduction and Negotiation of STARS

      Barclays and KPMG, an audit, tax and advisory firm, developed and

promoted STARS to U.S. banks. KPMG introduced STARS to BNY during

discussions with BNY’s tax director. Thereafter, tax professionals at KPMG and

Barclays presented STARS to BNY through various meetings, discussions,

promotional materials and correspondence.

      STARS was represented as a “below market loan” in KPMG’s initial

presentation. KPMG indicated that STARS required a U.K. counterparty and a

certain trust structure holding income-producing assets. KPMG explained that the
                                          -5-

below-market cost would be achieved by the U.K. counter party “sharing” U.K. tax

benefits from STARS through an offset to the cost of the loan. Finally, KPMG

indicated that the U.K. tax benefits would be generated by subjecting income-

producing assets held by a trust to U.K. tax and thus generating foreign tax credits

that BNY could use to offset its U.S. tax liability.

      BNY notified KPMG in August 2001 that it was prepared to move forward

with a STARS transaction with Barclays as the U.K. counterparty. BNY proposed

that it would contribute assets that would generate $93 million of annual U.K. tax

costs and expected Barclays to reduce the loan’s annual cost by half that amount.

Shortly thereafter, BNY agreed to supplement STARS by engaging in a “stripping

transaction.” The effect would be to accelerate and increase the tax benefits

STARS produced (i.e., foreign tax credits). And just before STARS closed, BNY

indicated to Barclays that it had decided to increase the targeted benefit.

III. The STARS Transaction

      BNY closed the STARS transaction with Barclays in November 2001. The

key components of STARS were as follows.
                                         -6-

      A. The STARS Structure

      BNY used existing subsidiaries and created special-purpose entities to create

a structure (STARS structure) to carry out the STARS transaction. BNY

accomplished this by engaging in the following steps.

             1. Step 1: REIT Holdings Funded

      BNY contributed $6.46 billion of assets (BNY assets) to BNY REIT

Holdings, LLC (REIT Holdings), an existing BNY subsidiary treated as a

corporation for U.S. tax purposes. The BNY assets consisted of participating

interests in residential mortgage loans, commercial mortgage loans and consumer

loans (participation interests) and various asset-backed and agency securities. REIT

Holdings assumed $2.55 billion of BNY’s liabilities (BNY liabilities) in connection

with the contribution.

             2. Step 2: InvestCo Organized and Funded

      BNY organized BNY Investment Holdings (DE), LLC (InvestCo), as a

Delaware limited liability company. InvestCo elected to be taxed as a corporation

for U.S. tax purposes and was part of BNY’s affiliated group. REIT Holdings

capitalized InvestCo by contributing $10.409 billion of assets, consisting of the

BNY assets and BNY Real Estate Holdings, LLC’s common stock (the REIT

share), with a stated value of $3.95 billion (collectively, the STARS assets). In
                                           -7-

exchange, InvestCo assumed the BNY liabilities and issued a 100% ownership

interest in InvestCo to REIT Holdings.

             3. Step 3: DelCo Organized and Funded

      BNY organized BNY Delaware Funding (DE), LLC (DelCo), as a Delaware

limited liability company. DelCo elected partnership tax treatment for U.S. tax

purposes. InvestCo capitalized DelCo by contributing $9.243 billion worth of the

STARS assets. In exchange, DelCo assumed the BNY liabilities and issued to

InvestCo all of its class 1 ordinary shares (DelCo class 1 shares) worth $65 million

and its class 2 ordinary shares (DelCo class 2 shares) worth $6.628 billion.

      The DelCo class 1 shares held all the voting rights in DelCo. The DelCo

class 2 shares had the right to receive approximately 99% of DelCo’s distributions.

The holders of DelCo class 1 shares had the exclusive right to appoint DelCo’s

managers. DelCo’s income was distributable in the absolute discretion of DelCo’s

managers.

             4. Step 4: Organization, Funding and Terms of the STARS Trust

      BNY formed the BNY STARS Trust (trust) as a common law trust. The trust

was authorized to issue class A units, a class B unit, a class C unit and a class D

unit (collectively, the trust units). The trust unit holders were contractually entitled

to monthly distributions in the following order. The class A unit holders were
                                          -8-

entitled to 1% of the trust distributable income. The class D unit holder was entitled

to trust distributable income equal to $25 million x (1-month LIBOR5 + 415 basis

points (basis points)) x 0.78. The class B unit holder was entitled to 99% of the

remaining distributable income, if the class C unit was in issue, or all remaining

distributable income if the class C unit was not in issue. The class C unit holder

was entitled to the remaining trust distributable income unless a default occurred.

      InvestCo transferred the remaining STARS assets (approximately $1.2

billion) and the DelCo class 2 shares to the trust in exchange for the class A units

and the class B unit, which had stated values of $6.3 billion and $1.494 billion,

respectively.

      The initial trustee was BNY, acting through its London branch (U.S. trustee).

The Bank of New York (DE), a wholly-owned subsidiary of BNY Parent, served as

the trust manager. Only the holder of all the class A units could nominate a

replacement trustee.




      5
        “LIBOR” is an acronym for “London Interbank Offering Rate.” See
generally Bank One Corp. v. Commissioner, 

, 189 (2003), aff’d in
part, vacated in part and remanded sub nom. J.P. Morgan Chase & Co. v.
Commissioner, 

 (7th Cir. 2006).
                                        -9-

            5. Step 5: Organization and Ownership of NewCo

      BNY organized BNY NewCo Funding (DE), LLC (NewCo), as a Delaware

limited liability company, with InvestCo as its sole member. NewCo elected

partnership treatment for U.S. tax purposes. InvestCo contributed 49% of the class

A units to NewCo in exchange for a membership interest with a $3.089 billion

stated value. This resulted in InvestCo having a 100% ownership interest in

NewCo. InvestCo then distributed 1% of its NewCo interest to REIT Holdings.

      In sum, the above steps moved approximately $7.86 billion in net assets into

DelCo and the trust. The following chart summarizes steps 1 through 5.
                                        -10-




      B. The STARS Loan

      BNY and Barclays entered into the following agreements and transactions,

the net effect of which was to create a $1.5 billion loan to BNY from Barclays.

             1. Class C Unit and Class D Unit Subscription

      First, Barclays purchased the class C unit for $1.469 billion and the class D

unit for $25 million from the trust by a subscription agreement. The subscription
                                         -11-

agreement required Barclays to pay further subscription amounts to the trust equal

to the amount of any distributions on the class C unit. To ensure this, BNY

established a blocked account in Barclays’ name that Barclays could not access or

control (Barclays blocked account). Also, BNY and Barclays agreed that all class C

unit distributions were to be paid to the Barclays blocked account, and all further

subscription amounts Barclays owed were to be paid from the Barclays blocked

account.

             2. Trust Class C Unit and Class D Unit Forward Sale Agreements

      Second, InvestCo and Barclays entered into a forward sale agreement

obligating InvestCo to purchase the class C unit (class C unit forward sale

agreement) from Barclays in November 2006, or earlier in the event of default or

acceleration, for $1.498 billion. The sale price under the class C unit forward sale

agreement was equal to the $1.475 billion principal plus interest compounded

annually at 4.338% less a fixed amount based on the amount of U.K. taxes paid on

the trust income.

      Investco and Barclays entered into another forward sale agreement obligating

InvestCo to purchase the class D unit (class D unit forward sale agreement ) from

Barclays within 90 days of the purchase by InvestCo of the class C unit, for $25

million plus any additional amount for any accrued but unpaid distributions on the
                                         -12-

class D unit. The sale price under the class D unit forward sale agreement was the

same as the original subscription price of the class D unit.

             3. Zero Coupon Swap

      Third, InvestCo and Barclays entered into a zero coupon swap agreement that

required InvestCo to make monthly payments equal to one-month dollar LIBOR

plus 30 basis points by reference to a $1.475 billion notional amount, less a spread

amount (spread). The spread was a fixed amount equal to one-half of the present

value of the expected U.K. taxes on the target class C unit income (discussed

below) each month. In exchange for InvestCo’s monthly payments, Barclays agreed

to pay $23 million to InvestCo on the zero coupon swap maturity date in November

2006. The payment was designed to equal the amount that exceeded the $1.475

billion InvestCo was obligated to pay under the class C unit forward sale agreement

if it continued in force until its expiration in November 2006.

             4. Guaranty and Security for InvestCo’s Obligations Under the
                Forward Sale Agreements and Zero Coupon Swap

                    a. Guaranty

      Barclays and BNY entered into a credit default swap in November 2001.

Under the credit default swap, BNY guaranteed all obligations of InvestCo under
                                           -13-

the forward sale agreements and the zero coupon swap to Barclays in case of

InvestCo’s bankruptcy or default. In exchange, Barclays paid a fixed rate of 10

basis points on the notional amount of $1.475 billion.

                     b. Security Arrangements

       To secure InvestCo’s obligations under the forward sale agreements and the

zero coupon swap, the trust and DelCo each pledged a portion of the STARS assets

(consisting of asset-backed and agency securities) as collateral. The trust

transferred $1.432 billion of securities (trust collateral securities) to a collateral

account, and DelCo transferred $1.166 billion of securities (DelCo collateral

securities) to another collateral account (DelCo securities account). Proceeds from

the securities were held in the same accounts, respectively. Barclays was granted a

security interest in the trust securities account and the DelCo securities account

(collectively, collateral accounts). BNY acted as the securities intermediary for the

assets held in these accounts. BNY guaranteed through a participation agreement

that the trust and DelCo together would hold at least $2.25 billion worth of high-

quality securities as collateral for so long as Barclays held the class C unit.
                                        -14-

             5. Net Effect of the Subscription Agreements, Forward Sale
                Agreements and Zero Coupon Swap

      In sum, the forward sale agreements, the zero coupon swap and the security

arrangements converted Barclays’ initial subscriptions for the class C unit and class

D unit into a secured loan from Barclays to BNY for $1.5 billion at LIBOR plus 20

basis points (loan).6 BNY would pay the interest on the loan through the monthly

LIBOR-based amounts under the zero coupon swap, excluding the spread. BNY

would repay the principal through the forward sale prices, net of the fixed payment

of the zero coupon swap.

      The following diagram broadly reflects the terms of the various agreements

making up the loan.




      6
      For simplicity, we net the zero coupon swap floating leg, the credit default
swap payment and the class D unit distributions in referring to the interest rate
(LIBOR plus 20 basis points) on the loan.
                                         -15-




      C. Use of the STARS Loan Proceeds

      The trust immediately redeemed InvestCo’s class B unit with the $1.494

billion the trust received from Barclays’ purchase of the class C unit and the class D

unit. InvestCo then placed $1.5 billion on deposit with a BNY branch office in the

Cayman Islands (Cayman branch). After an initial 11-day term, the money was held

on deposit at the Cayman branch in 1-month terms for the duration of STARS. The

Cayman branch booked this deposit as a liability to Barclays.
                                          -16-

      D. Replacement of the U.S. Trustee

      BNY and Barclays replaced the U.S. trustee with The Bank of New York

Trust and Depositary Company Limited (U.K. trustee), which was treated as a U.K.

resident for U.K. tax purposes. The U.K. trustee was a wholly-owned subsidiary of

BNY parent.

      E. The Stripping Transaction

      The parties entered into a series of agreements slightly over a month after

STARS closed to accelerate the U.K. taxes due on trust income by converting

periodic cashflows into an up-front taxable lump-sum payment (stripping

transaction). These agreements contemplated the following steps.

      First, BNY would contribute $402 million to DelCo through REIT Holdings,

InvestCo and the trust. Second, the U.K. trustee would transfer the trust collateral

securities to BNY as “custodian” in exchange for principal-only receipts and

interest-only receipts. Third, DelCo would use the contributed funds to purchase

the interest-only receipts from the trust for $402 million. Fourth, the collateral

arrangements would be amended so that Barclays obtained a security interest in the

principal-only receipts and the interest-only receipts.

      To effect the stripping transaction, the trust exchanged the trust collateral

securities for the interest-only receipts and principal-only receipts, which
                                          -17-

represented beneficial ownership in the interest payments and principal payments,

respectively. DelCo then purchased the interest-only receipts for $402 million from

the trust. The funds used to purchase the interest-only receipts were not transferred

in accordance with steps contemplated in the transaction documents. Instead, BNY

transferred $402 million directly to the trust’s bank account.

      Barclays was granted a security interest in the principal-only and interest-only

receipts that were transferred to a trust security account and DelCo security account,

respectively.

      For U.K. tax purposes, the trustee treated the $402 million from the sale of

the interest-only receipts as taxable income at the time of the sale. The U.K. trustee

was required to pay U.K. taxes on the taxable income. Under U.S. tax rules,

however, the trust did not report a gain or loss.

      The post-tax income from the stripping transaction was distributed to the

class C unit holder in the next monthly period. BNY received its benefit, a portion

of the spread, over a period of 14 months.

      Net the stripping transaction added $402 million in income to the trust, over

and above the monthly target amount, that was taxable in the United Kingdom and

generated additional trust taxes and foreign tax credits of $88 million in 2001.
                                         -18-

      BNY ignored the stripping transaction in managing and disposing of the

stripped securities. When the trust manager sold a stripped security, the trust

manager would reconstitute the security and withdraw it from the collateral pool.

      F. Management and Control of Trust Assets and DelCo Assets

      The trust manager held absolute discretion in managing the trust assets. The

trust manager delegated its authority to BNY through a servicing agreement for

which BNY received a monthly fee. BNY also agreed to manage DelCo’s assets

for a monthly fee and was authorized to take any necessary action.

      G. Allocation of STARS Risk

      BNY and Barclays also took steps to apportion risk associated with STARS.

These steps are as follows.

             1. Trust Class C Target Distributions and Indemnity Payments
                for Shortfalls

      BNY and Barclays executed agreements to protect against trust target income

shortfalls. The class C unit forward sale agreement provided that InvestCo would

pay an indemnity amount if any class C unit distribution was less than a certain

target amount for each period ($12 million for period 1, $338 million for period 2

and $30 million for all other periods). The class C unit indemnity amount equaled
                                          -19-

additional U.K. trust taxes (future valued) that the trust would pay if it met the target

class C unit distribution.

             2. STARS Termination Rights

      BNY and Barclays also included contractual mechanisms for each party to

terminate the STARS transaction on short notice. Barclays and InvestCo each had

the right, with or without cause, to accelerate the class C unit or the class D unit

forward sale date by serving a notice of a forward sale date not less than 5 days nor

more than 30 days after the notice (exit provision).

             3. Allocation of U.K. Tax Risk

      Additionally, BNY and Barclays agreed to certain provisions allocating U.K.

tax risk. BNY agreed under one provision to pay Barclays half of any trust tax that

was refunded if the U.K. tax authority did not respect Barclays’ U.K. tax position

with respect to the trust. In addition, Barclays and InvestCo agreed under another

provision to indemnify each other for one-half of any U.K. stamp duty reserve tax

imposed as a result of either forward sale agreement.

IV. U.K. Tax Treatment of STARS

      A. Disclosure of STARS to the U.K. Tax Authority

      Barclays engaged in transactions substantially similar to STARS with other

U.S. banks. Barclays disclosed one of those transactions to the U.K. tax authority
                                         -20-

in June 2001 while it was negotiating STARS with BNY. Barclays disclosed the

STARS transaction in April 2002 to the U.K. tax authority. The U.K. tax authority

advised Barclays that it agreed with Barclays’ tax reporting of the STARS

transaction in June 2002. The STARS transaction increased tax revenue for the

United Kingdom.

      B. U.K. Tax Treatment of the Trust

      The trust was treated as an unauthorized unit trust under U.K. law that

qualified as a collective investment scheme under the applicable U.K. regulatory

laws. When the U.K. trustee replaced the U.S. trustee, the trust became subject to

U.K. tax as a collective investment scheme for purposes of U.K. law. As a result,

the income arising from the trust assets was treated as income of the U.K. trustee,

which was subject to a 22% U.K. income tax under section 469 of the U.K. Income

and Corporations Taxes Act 1988. That U.K. income tax paid was a liability of the

U.K. trustee and not of any of the trust unit holders. The U.K. trustee owed the

U.K. income tax whether the trust made actual distributions to the trust unit holders.

      C. U.K. Tax Treatment of Barclays

      Under U.K. law, Barclays, as a trust unit holder, was deemed to receive

annual payments from the trust. Barclays owed U.K. corporation tax at a 30% rate
                                          -21-

on those deemed annual payments even if Barclays did not receive any trust

distributions. The deemed annual payments were equal to the income available for

distribution from the trust to Barclays as holder of the class C unit and class D unit,

grossed up for 22% U.K. income tax. Barclays was entitled to a U.K. tax credit of

22% on the deemed annual payment. Barclays could also claim a U.K. deduction

for contributing the class C unit distributions and for the spread amount paid to

InvestCo through the zero coupon swap.

V. STARS Cashflows

      The STARS participants made various payments and monthly distributions

throughout STARS. These payments and distributions are explained as follows.

      A. DelCo Distributions

      DelCo held most of the STARS assets at closing. DelCo made monthly

distributions to InvestCo (class 1 shareholder) and the trust (class 2 shareholder)

with InvestCo receiving 1% and the trust receiving the remaining 99%. The

monthly distributions to the trust were sufficient for the trust to meet the target

distributions to Barclays. When DelCo’s income did not meet projected DelCo

distributions, DelCo satisfied the difference from its cash on hand. BNY also

arranged for the contribution of more income-producing assets to DelCo.
                                             -22-

      B. Trust Distributions

      The trust generated income from the trust assets and DelCo class 2

distributions. The trust set aside 22% of the trust income in reserves for U.K. taxes,

which were periodically sent to the U.K. tax authority. The remaining income was

distributed monthly to trust unit holders.

      The trust made monthly class C unit distributions to the Barclays blocked

account. Those distributions were approximately equal to the corresponding target

distribution amounts. Barclays immediately contributed these distributions to the

trust to satisfy its obligation to pay further subscription amounts. The trust also

made the required monthly class D unit distributions to Barclays. Barclays retained

all of these distributions, totaling $7 million over the term of STARS.

      Finally, the trust made monthly contributions to DelCo of amounts at least

equaling but often substantially exceeding the corresponding contributed income

amount from the Barclays blocked account starting after the first nine months of

STARS.

      C. Zero Coupon Swap and Credit Default Swap Payments

      InvestCo or Barclays made monthly payments as required under the zero

coupon swap. LIBOR was 2.09% when STARS closed and stayed below 3% until

almost mid-2005. During that period, the spread due from Barclays under the zero
                                         -23-

coupon swap was greater than the LIBOR plus 30 basis points amount due from

InvestCo. Barclays made net payments to InvestCo under the zero coupon swap of

$12 million for 2001 and $51 million for 2002. Over the life of STARS, Barclays

made net payments to BNY of $82.6 million under the floating leg of the zero

coupon swap. Additionally, Barclays made all required payments to BNY under the

credit default swap.

VI. Termination of STARS

      STARS wound down and eventually terminated in late 2006 when InvestCo

and Barclays fulfilled their obligations under the forward sale agreements and the

zero coupon swap.

VII. BNY Tax Reporting of STARS

      The trust, DelCo and NewCo each filed Forms 1065, U.S. Return of

Partnership Income, for the years at issue. BNY reported the income from the

STARS assets as income on its U.S. consolidated return. It reported this income,

however, as foreign source. BNY claimed foreign tax credits of $98,607,973 and

$100,285,767 for 2001 and 2002, respectively, for payments made to the U.K. tax

authority with respect to the trust income.

      BNY treated the payments made to Barclays on the class D unit distributions

as a component of interest on the loan. With respect to the floating leg of the zero
                                           -24-

coupon swap, BNY netted the spread component and the LIBOR plus 30 basis

points component of the zero coupon swap. This treatment effectively resulted in

BNY claiming an interest deduction for the LIBOR plus 30 basis points interest

amount (zero coupon swap interest) for the years at issue as the spread component

exceeded the zero coupon swap interest component for each year. BNY reduced

unrelated interest expense by the net payments Barclays made to InvestCo under the

zero coupon swap for the years at issue.

      BNY claimed $835,100 and $6,753,720 as deductible expenses, fees and

transaction costs for 2001 and 2002, respectively.

VIII. Deficiency Notice

      Respondent timely issued a deficiency notice to petitioner and adjusted

petitioner’s taxable income by disallowing the foreign tax credits, disallowing

deductions for interest and transaction costs, and reclassifying income related to the

STARS transaction as U.S. source income.

                                      OPINION

      This complex transaction presents a case of first impression in this Court.

We are asked to decide whether petitioner is entitled to foreign tax credits and

certain expense deductions from the STARS transaction and also whether petitioner

is entitled to report income generated from the STARS assets as foreign source
                                         -25-

income. Respondent argues that the STARS transaction lacked economic substance.

Respondent asserts consequently that the foreign tax credits and expenses

attributable to STARS should be disallowed and the income from the STARS assets

should be characterized as U.S. source.7 Petitioner, in contrast, contends the

STARS transaction had economic substance. In this regard, petitioner asserts that

BNY entered into STARS to obtain low-cost funding for its banking business and

that it reasonably expected to earn a pre-tax profit from STARS. Additionally,

petitioner contends that the U.S. foreign tax credit was intended for transactions like

STARS.

      We agree with respondent. The STARS transaction was structured to meet

the relevant requirements in the Code and the regulations for claiming the disputed

foreign tax credits. The STARS transaction in essence, however, was an elaborate

series of pre-arranged steps designed as a subterfuge for generating, monetizing and

transferring the value of foreign tax credits among the STARS participants. We

now turn to the merits of the STARS transaction under the economic substance

doctrine.


      7
        Respondent also argues that the foreign tax credits BNY claimed are
disallowed under substance over form doctrines (including the step transaction
doctrine) and under the statutory anti-abuse rule in sec. 269(a). We need not decide
these arguments because of our other holdings.
                                        -26-

I. Merits of the STARS Transaction Under the Economic Substance Doctrine

      A. Overview

      Taxpayers may structure business transactions in a manner that results in the

least amount of tax. See Boulware v. United States, 

, 430 n.7 (2008)

(citing Gregory v. Helvering, 

, 469 (1935)); Gerdau Macsteel, Inc. v.

Commissioner, 

___, ___ (slip op. at 163-164) (Aug. 30, 2012). Courts

have also long recognized, however, that even if a transaction complies literally with

the Code, it does not necessarily follow that Congress intended to cover the

transaction and allow a tax benefit. Knetsch v. United States, 

, 365

(1960); Helvering v. Gregory, 

, 810 (2d Cir. 1934), aff’d, 

(1935). In Frank Lyon Co. v. United States, 

, 583-584 (1978), the

Supreme Court explained the circumstances in which a transaction should be

respected for tax purposes:

      [W]here, as here, there is a genuine multiple-party transaction with
      economic substance which is compelled or encouraged by business or
      regulatory realities, is imbued with tax-independent considerations, and
      is not shaped solely by tax-avoidance features that have meaningless
      labels attached, the Government should honor the allocation of rights
      and duties effectuated by the parties. * * *

      The Courts of Appeals have interpreted that language as creating an

“economic substance doctrine” with the following two prongs: (1) whether the
                                        -27-

transaction had economic substance beyond tax benefits (objective prong), and (2)

whether the taxpayer had shown a non-tax business purpose for entering into the

disputed transaction (subjective prong). See Gerdau Macsteel, Inc. v.

Commissioner, 

at ___ (slip op. at 166); Reddam v. Commissioner, T.C.

Memo. 2012-106; see also New Phoenix Sunrise Corp. & Subs. v. Commissioner,

, 175 (2009), aff’d, 408 Fed. Appx. 908 (6th Cir. 2010); Blum v.

Commissioner, T.C. Memo. 2012-16.

      There is a split among the Courts of Appeals, however, as to the proper

application of the economic substance doctrine, and alternative approaches have

emerged. Some Courts of Appeals require that a valid transaction have economic

substance or a non-tax business purpose. See, e.g., Horn v. Commissioner, 

, 1236-1238 (D.C. Cir. 1992), rev’g Fox v. Commissioner, T.C. Memo.

1988-570; Rice’s Toyota World, Inc v. Commissioner, 

, 91 (4th Cir.

1985), aff’g in part, rev’g in part 

 (1983). Other Courts of Appeals

require a valid transaction have both economic substance and a non-tax business

purpose. See Dow Chem. Co. v. United States, 

, 599 (6th Cir. 2006);

Winn-Dixie Stores, Inc. v. Commissioner, 

, 1316 (11th Cir. 2001),

aff’g 

 (1999); United Parcel Serv. of Am., Inc. v. Commissioner, 

, 1018 (11th Cir. 2001), rev’g T.C. Memo. 1999-268. Still other Courts
                                         -28-

of Appeals adhere to the view that a lack of economic substance is sufficient to

invalidate a transaction regardless of the taxpayer’s subjective motivation. See, e.g.,

Coltec Indus., Inc. v. United States, 

, 1355 (Fed. Cir. 2006). And

still other Courts of Appeals treat the objective and subjective prongs merely as

factors to consider in determining whether a transaction has any practical economic

effects beyond tax benefits. See, e.g., ACM P’ship v. Commissioner, 

,

248 (3d Cir. 1998), aff’g in part, rev’g in part T.C Memo. 1997-115.

      An appeal in this case would lie to the Court of Appeals for the Second

Circuit absent stipulation to the contrary, and, accordingly, we follow the law of that

circuit to the extent it is directly on point. See Golsen v. Commissioner, 

 (1970), aff’d, F.2d 985 (10th Cir. 1971). The Court of Appeals for the Second

Circuit has endorsed applying a flexible analysis in assessing economic substance.

Gilman v. Commissioner, 

 (2d Cir. 1991), aff’g T.C. Memo. 1989-684;

Long Term Capital Holdings v. United States, 

 (D. Conn.

2004), aff’d, 150 Fed. Appx. 40 (2d Cir. 2005). The analysis evaluates both the

subjective business purpose of the taxpayer for engaging in the transaction and the

objective economic substance of the transaction. Gilman v. Commissioner, 933

F.2d at 148; Long Term Capital Holdings, 330 F. Supp. 2d at 171. These distinct

aspects of the economic substance inquiry do not, however, constitute discrete
                                         -29-

prongs of a rigid two-step analysis. Long Term Capital Holdings, 330 F. Supp. 2d

at 171 n.68; see also Gilman v. Commissioner, 933 F.2d at 148. They are instead

simply more precise factors to consider in the overall inquiry of whether the

transaction had any practical economic effects other than the creation of tax losses.

Altria Grp. Inc. v. United States, 

, 282 (S.D.N.Y. 2010), aff’d,

 (2d Cir. 2011); Long Term Capital Holdings, 330 F. Supp. 2d at 171

n. 68. A finding of a lack of either economic substance or a non-tax business

purpose can be but is not necessarily sufficient for a court to conclude that a

transaction is invalid for Federal tax purposes. Altria Group, Inc., 694 F. Supp. 2d

at 282; Long Term Capital Holdings, 330 F. Supp. 2d at 171 n.68. The ultimate

determination of whether a transaction lacks economic substance is a question of

fact. See Nicole Rose Corp. v. Commissioner, 

, 284 (2d Cir. 2003),

aff’g 

 (2001). We now turn to the scope of the economic substance

doctrine.

      B. Scope of the Economic Substance Inquiry

      The first step in the economic substance inquiry is to identify the transaction

to be analyzed. See, e.g., Sala v. United States, 

, 1252 (10th Cir.

2010). Petitioner argues that we should analyze the components of the STARS

transaction as an integrated arrangement for purposes of testing economic
                                          -30-

substance. In contrast, respondent argues that we should bifurcate the STARS

transaction and focus on the STARS structure, not the loan, for purposes of testing

economic substance. We agree with respondent.

      The relevant transaction to be tested is the one that produces the disputed tax

benefit, even if it is part of a larger set of transactions or steps.8 See Nicole Rose

Corp. v. Commissioner, 320 F.3d at 284; Kipnis v. Commissioner, T.C. Memo.

2012-306; Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251; Long

Term Capital Holdings, 330 F. Supp. 2d at 183; see also Sala, 613 F.3d at 1252;

Klamath Strategic Inv. Fund v. United States, 

, 545 (5th Cir. 2009);

Coltec Indus., Inc., 454 F.3d at 1352-1355; Black & Decker Corp. v. United States,

, 436 (4th Cir. 2006); ACM P’ship v. Commissioner, 157 F.3d at 260

n.57. Stated another way, the requirements of the economic substance doctrine are

not avoided simply by coupling a routine transaction with a transaction lacking

economic substance. See, e.g., Long Term Capital Holdings, 330 F. Supp. 2d at


      8
        Congress noted when codifying the economic substance doctrine in sec.
7701 in 2010 that under present law courts could “bifurcate a transaction in which
independent activities with non-tax objectives are combined with an unrelated item
having only tax avoidance objectives to disallow those tax motivated benefits.”
Staff of Jt. Comm. on Taxation, Technical Explanation of the Revenue Provisions of
the “Reconcilliaton Act of 2010” as amended, in combination with the “Patient
Protection and Affordable Care Act” 153 & n.352 (J. Comm. Print 2010).
                                         -31-

183; see also ACM P’ship v. Commissioner, 157 F.3d at 260 n.57. A contrary

application would undermine the flexibility and efficacy of the economic substance

doctrine.

      Accordingly, we focus our economic substance inquiry on the transaction that

gave rise to the disputed foreign tax credits. The disputed foreign tax credits were

generated by circulating income through the STARS structure. In contrast, the loan

was not necessary for the STARS structure to produce the disputed foreign tax

credits. It is the use of the STARS structure then that is relevant and that we test for

economic substance.

      C. Economic Substance of the STARS Structure

             1. Objective Economic Substance

      We first consider whether BNY’s use of the STARS structure had objective

economic substance. The Court of Appeals for the Second Circuit in evaluating

objective economic substance focuses on whether the relevant transaction created a

reasonable opportunity for economic profit; i.e., profit exclusive of tax benefits.

Gilman v. Commissioner, 933 F.2d at 148; Long Term Capital Holdings, 330 F.

Supp. 2d at 172. Accordingly, we must determine whether use of the STARS

structure created a reasonable opportunity for economic profit. Respondent argues
                                          -32-

that it did not. We agree and thus find that the use of the STARS structure lacked

objective economic substance.

      The record reflects that BNY did not have a reasonable expectation that it

would make a non-tax economic profit from using the STARS structure. First, the

STARS structure did not increase the profitability of the STARS assets in anyway.

To the contrary, it reduced their profitability by adding substantial transaction costs,

e.g., professional service fees and foreign taxes incurred as result of using the

STARS structure.9


      9
        We have previously held that foreign taxes are economic costs for purposes
of the economic substance doctrine. See Compaq Computer Corp. v.
Commissioner, 

 (1999), rev’d, 

, 785 (5th Cir. 2001). We
are mindful that the Courts of Appeals for the Fifth and Eighth Circuits have
subsequently held that foreign taxes should not be taken into account in evaluating
pre-tax effects for purposes of the economic substance analysis. See IES Indus.,
Inc. v. United States, 

 (8th Cir. 2001); Compaq Computer Corp. v.
Commissioner, 

, 785 (5th Cir. 2001), rev’g 

 (1999).
Nevertheless, the Supreme Court and the Court of Appeals for the Second Circuit
have yet to consider the issue, and we are not bound by Fifth and Eighth Circuit
precedent here.

       We maintain the position we took in Compaq Computer with respect to
foreign taxes in the economic substance context. Economically, foreign taxes are
the same as any other transaction cost. And we cannot find any conclusive reason
for treating them differently here, especially because substantially all of the foreign
taxes giving rise to the foreign tax credits stemmed from economically meaningless
activity, i.e., the pre-arranged circular cashflows engaged in by the trust.

                                                                          (continued...)
                                        -33-

      Additionally, the activities or transactions that the STARS structure was used

to engage in did not provide a reasonable opportunity for economic profit. The

STARS structure’s main activity was to circulate income between itself and

Barclays. Every month, as pre-arranged, DelCo would transfer pre-determined

amounts of income to the trust. Substantially all of the trust income was distributed

to the Barclays blocked account, which in turn was immediately recontributed to the

trust and then passed back to DelCo where it was available for BNY’s use. These

circular cashflows or offsetting payments had no non-tax economic effect.

      Courts have consistently recognized that the presence of circular cashflows

strongly indicates that a transaction lacks economic substance. See Altria Group,

Inc., 658 F.3d at 289 (citing AWG Leasing Trust v. United States, 

, 983 (N.D. Ohio 2008)) (circular payments from and back to foreign bank

“strongly indicate” that SILO transaction “has little substantive business purpose

other than generating tax benefits”); Merryman v. Commissioner, 

, 882




      9
       (...continued)
      Additionally, excluding the economic effect of foreign taxes from the pre-tax
analysis would fundamentally undermine the point of the economic substance
inquiry. That point is to remove the challenged tax benefit and evaluate whether the
relevant transaction makes economic sense. See In re CM Holdings, Inc., 

, 105 (3d Cir. 2002).
                                          -34-

(5th Cir. 1989) (tax structuring disregarded where “money flowed back and forth

but the economic positions of the parties were not altered”), aff’g T.C. Memo.

1988-72; Prof’l Servs. v. Commissioner, 

, 928 (1982) (disregarding pre-

arranged circular cashflows through a trust); see also Knetsch, 364 U.S. at 366

(offsetting payments on annuity bond and notes resulted in sham). This follows

from the common sense proposition that a taxpayer is not entitled to benefits from

circular transfers the net result of which is effectively nothing.

      The STARS structure was also used in connection with the stripping

transaction. The stripping transaction too resulted in a circular cashflow and did not

provide a reasonable opportunity for economic profit. In particular, the trust sold its

right to interest income from the trust collateral securities to DelCo for a lump-sum

payment taxable in the United Kingdom, which DelCo made with funds provided by

BNY. This reallocated the income and principal payments associated with the trust

collateral securities within the STARS structure. It did not alter the amount and

timing of the cashflows generated by the underlying assets. And because the sale of

the interest rights was funded by BNY and between entities within the STARS

structure, the stripping transaction had no potential to generate a non-tax economic

profit on the aggregate.
                                          -35-

      Petitioner argues that we should consider the income generated by the

STARS assets in evaluating whether the STARS structure had a reasonable

opportunity for economic profit. We disagree. Economic benefits that would result

independent of a transaction do not constitute a non-tax benefit for purposes of

testing its economic substance. See Gerdau Macsteel, Inc. v. Commissioner, 

at ___ (slip op. at 174-175). Stated otherwise, benefits that are unrelated to

the transaction cannot be what motivates a taxpayer to engage in the transaction and

therefore are of no aid in determining whether the taxpayer would have engaged in

the transaction absent the tax effects. Id.

      Here, BNY’s control and management over the STARS assets did not

materially change as a result of their transfer to the STARS structure.10

Additionally, the STARS structure had no effect on the income stream generated by

the STARS assets. Accordingly, the STARS assets would have generated the same




      10
         DelCo held most of the income-generating STARS assets with the trust
holding the remaining STARS assets. BNY directly or indirectly held all the voting
rights of DelCo, the initial and successor trustee of the trust and the trust manager,
and thus effectively controlled those entities. In addition, BNY executed servicing
agreements that gave BNY control over the management of the STARS assets the
trust and DelCo held.
                                         -36-

income regardless of being transferred to the trust. Thus, income from the STARS

assets was not an incremental benefit of STARS.

             2. Subjective Economic Substance

      We now turn to the subjective prong of the economic substance analysis.

This prong requires us to determine whether BNY had a legitimate non-tax business

purpose for the use of the STARS structure. See Long Term Capital Holdings, 330

F. Supp. 2d at 186. We find it did not. Petitioner claims that it used the STARS

structure to obtain “low cost financing” from Barclays.11 The record does not

support petitioner’s claimed business purpose. The STARS structure lacked any

reasonable relationship to the loan. And the loan was not “low cost.” To the

contrary, it was significantly overpriced and required BNY to incur substantially

more transaction costs than a similar financing available in the marketplace. We

find that petitioner failed to establish a valid business purpose and BNY’s true

motivation was tax avoidance. We base our finding on our analysis of the following

factors.


      11
         Petitioner’s experts opined on several other potential business purposes at
trial. The record does not support, however, that BNY contemplated those
suggested business purposes at the time it participated in STARS. We therefore
reject these after-the-fact rationalizations. See, e.g., Winn-Dixie Stores, Inc. v.
Commissioner, 

, 285-286 (1999), aff’d, 

 (11th Cir.
2001).
                                          -37-

                    a. The STARS Structure Lacked a Reasonable Relationship to
                       Petitioner’s Claimed Business Purpose.

      Using unreasonable means to achieve a claimed business purpose indicates

that the taxpayer’s true motivation for the transaction is tax avoidance. See Long

Term Capital Holdings, 330 F. Supp. 2d at 186-187; see also Cherin v.

Commissioner, 

, 993-994 (1987); CMA Consol., Inc. & Subs. v.

Commissioner, T.C. Memo. 2005-16. We now consider the relationship between

the STARS structure and petitioner’s claimed business purpose. Petitioner suggests

that the class C unit and the class D unit Barclays held served as collateral for the

loan. We are not persuaded.

      BNY’s obligation with respect to the loan was more than adequately secured

by other arrangements independent of the trust. Barclays held a security interest in

a pool of high quality assets valued at $2.25 billion, creating a collateralization level

of 150%. Respondent’s expert Steven Schwarcz concluded that the collateralization

level (e.g., securitization) in a structured finance transaction is usually around 10%

and that the loan was substantially over collateralized. In addition to the collateral

arrangements, Barclays effectively had full recourse to BNY itself for repayment

through the credit default swap.
                                          -38-

      Petitioner’s expert W. Clifford Atherton suggested that the special-purpose

entities making up the STARS structure served a project financing (a type of

structured financing transaction) function. We disagree. Respondent’s expert Mr.

Schwarcz emphasized that special-purpose entities are typically used in connection

with a structured financing transaction to efficiently reallocate risk and reduce

information asymmetry.12 Mr. Schwarcz also highlighted that structured financing

transactions generally involve special-purpose entities incurring debt and using the

proceeds to finance the acquisition of income-producing assets. And the lenders

look to the cash produced by those assets for repayment, bearing the risk that the

cash will be insufficient to repay the debt.

      These common indicia of a structured financing transaction are not present in

STARS. The loan proceeds were not used to purchase the STARS assets, and

Barclays did not look to any assets purchased with the financing proceeds for

repayment. And unlike a typical structured financing transaction, the special-

purpose entities in STARS did not function to efficiently reallocate risk.



      12
        Mr. Schwarcz defined “information asymmetry” as a scenario in which one
party has more information than the other party. According to Mr. Schwarcz,
structured financing transactions reduce information asymmetry by allowing parties
taking on risk to more efficiently assess that risk, typically by creating well-defined,
easily-valued and bankruptcy-protected sources of repayment.
                                         -39-

       In this regard, Mr. Schwarcz observed that STARS simply involved a full-

recourse secured financing. Mr. Schwarcz correctly concluded that, given the

characteristics of the loan, Barclays could have made the same $1.5 billion loan to

BNY, secured by the same assets constituting the collateral for the loan, using only

a loan agreement and a security agreement. Such an arrangement would have been

much simpler, avoided the use of the special-purpose entities and had substantially

lower transaction costs than STARS.

       Efficiency aside, Mr. Schwarcz concluded that the special-purpose entities

used in the STARS transaction did not “realistically” function to transfer risk

between the parties. Mr. Schwarcz opined that the over-collateralization level of

the loan and the other security arrangements minimized Barclays’ risk with respect

to the loan. Accordingly, there was no significant risk for the special-purpose

entities to transfer.

       Finally, Mr. Schwarcz concluded that the STARS structure did not reduce

information asymmetry between the parties. In contrast, he opined that STARS was

excessively complex given the economics of the loan and arguably increased

information asymmetry. We agree with Mr. Schwarcz that the STARS structure did

not perform a structured financing function.
                                          -40-

      Petitioner finally argues more generally that Barclays made the loan

contingent on the STARS structure and therefore the two transactions were

“commercially linked.” Again, we are not persuaded. Making a routine business

transaction contingent on an economically meaningless transaction, like the STARS

structure, is insufficient to establish that the nexus between the two is reasonable.

See, e.g., Long Term Capital Holdings, 330 F. Supp. 2d at 183.

      In sum, the record does not support that the STARS structure performed any

significant banking, commercial or business function with respect to the loan.

Consequently, we find that the STARS structure did not bear a reasonable

relationship to the loan. This lack of reasonableness indicates BNY’s true

motivation--tax avoidance.

                    b. The STARS Financing Was Not Low Cost.

      We now evaluate petitioner’s claimed business purpose that the loan was

“low cost.” Respondent argues that the spread should be disregarded in determining

the cost of the loan and that the loan was overpriced absent the spread. We address

each of respondent’s contentions in turn.
                                         -41-

                          i. The Spread Was Not a Component of Interest.

      We now consider whether the spread should be disregarded in determining

the cost of the loan. Respondent argues that it should because the spread in

substance was a tax effect and not a component of interest. We agree.

      We are mindful in evaluating the substance of the spread that labels and

characterizations do not determine the tax consequences where they are inconsistent

with economic realities. Frank Lyon Co., 435 U.S. at 583-584 (labels must be

economically meaningful); TIFD III-E, Inc. v. United States, 

 (2d Cir.

2006); Saba P’ship v. Commissioner, T.C. Memo. 2003-31 (payments characterized

as consulting fees held to be a guaranteed return to a purported partner).

      The stated interest rate on the loan was LIBOR plus 30 basis points less the

spread. The spread was a fixed amount equal to one-half the present value of the

U.K. taxes the trust was expected to pay on the target class C unit income each

month. We acknowledge the spread was part of the formula for calculating the

interest expense on the loan. Its substance did not match, however, its form.

      Respondent’s expert Anthony Saunders opined on the commerciality of the

loan’s pricing. Mr. Saunders noted that the pricing of a loan generally depends on

the time value of money and the risks presented to the lender through the particular
                                         -42-

loan transaction. Mr. Saunders also noted that here the loan’s cost was such that

Barclays could not reasonably expect that the return (i.e., interest) it received from

BNY would exceed Barclays’ cost of funds. He further noted that, independent of

Barclays’ cost of funds, the interest rate was “negative” for most of the tenure of the

loan. That is, the “lender” (Barclays) was paying the “borrower” (BNY) to borrow

its funds. Mr. Saunders concluded that the loan’s pricing did not reflect the risk

inherent in the STARS transaction and more generally that the loan fundamentally

deviated from attributes of a standard banking transaction. He further concluded

that there were no unique economic conditions that might explain the non-economic

pricing.

      Respondent’s expert Mr. Schwarcz also opined on the commerciality of the

loan. Like Mr. Saunders, Mr. Schwarcz noted that the loan had a “negative interest

rate.” Mr. Schwarcz opined that, in an arm’s-length commercial lending

transaction, a loan would not bear a negative interest rate, absent unique

circumstances external to the loan, e.g., to avoid a loss or to effect government

policy, such as stimulus. He noted that it makes no economic sense for a lender to

pay a borrower interest on a loan absent such a circumstance. He concluded there

were no special circumstances that warranted the loan bearing a “negative interest

rate” and the loan was not commercially reasonable.
                                         -43-

      Respondent’s expert Michael Cragg analyzed the pricing of the loan,

including the economics of the spread. He concluded that circulating income

through the STARS structure generated the economic benefit labeled the “spread”

by combining certain U.S. and U.K. tax effects. Mr. Cragg’s analysis showed that it

would not have been economically beneficial for Barclays to pay BNY the spread

absent the U.K. tax benefits from STARS. Similarly, Mr. Cragg’s analysis showed

that the STARS arrangement would not have been beneficial to BNY absent the

foreign tax credits arising from the payment of U.K. tax on the trust income. Mr.

Cragg ultimately concluded that the spread was economically derived and

contingent on the parties receiving certain U.S. and U.K. tax treatment with respect

to the STARS structure and as a result was not a pre-tax cashflow.

      Petitioner denies that the spread was a tax effect because it was not expressly

contingent on either Barclays or BNY receiving any particular U.S. or U.K. tax

treatment or benefit. In this regard, petitioner asserts that BNY could under certain

circumstances keep the spread Barclays paid even if Barclays did not realize its

expected U.K. benefits.13 And petitioner asserts that Barclays’ obligation to pay


      13
        If the U.K. tax authority determined that the trust was not a collective
investment scheme before the due date of the U.K. trust tax, BNY could keep the
spread paid to date even though Barclays would not realize the anticipated U.K. tax
                                                                         (continued...)
                                        -44-

the spread did not vary depending on whether BNY’s U.S. tax treatment was

respected.

      Petitioner’s argument is unpersuasive. The manner in which the parties

agreed to allocate tax risk does not preclude the spread from being a tax effect. The

spread’s value was derivative of expected U.S. and U.K. tax effects. And it would

not have been paid going forward if either of those effects had been foreclosed.

Indeed, STARS would no longer be economically beneficial to either BNY or

Barclays and each could terminate STARS on short notice.14


      13
        (...continued)
benefits. After the first due date of U.K. tax on trust income, however, BNY was
obligated to pay Barclays half of any STARS trust tax that would be refunded if the
U.K. tax authority did not respect Barclays’ tax position with respect to the STARS
structure. That amount would be roughly equal to spread payments BNY had
received.

       We note that the risk of having to pay the spread before the first due date
without realizing the anticipated U.K. benefits was likely minimal. According to
petitioner’s U.K. regulatory expert, Michael Brindle, Q.C., the U.K. tax authority
would likely view the STARS structure as a collective investment scheme. In
addition, the STARS structure was promptly submitted to the U.K. tax authority for
approval and a similar transaction was already under review. And on net the
STARS transaction added revenue to the U.K. relative to its position without the
STARS transaction, increasing the likelihood that the U.K. tax authority would view
the STARS structure favorably.
      14
       Petitioner concedes that Barclays agreed to pay the spread based upon
expected U.K. tax benefits and that the spread was calculated as a percentage of
                                                                       (continued...)
                                         -45-

      In sum, we agree with respondent’s experts. The spread artificially reduced

the loan’s cost and lacked economic reality. In substance the spread was contingent

on the parties’ anticipated tax treatment and was unrelated to the time value of

money or the attendant risks associated with the loan. We conclude, on the record

as a whole, that the spread was in substance not a component of loan interest.

      The spread rather was a tax effect. It was embedded in the loan to serve as a

device for monetizing and transferring the value of anticipated foreign tax credits

generated from routing income through the STARS structure. That the generated

tax savings were used to offset the cost of the loan does not provide a valid non-tax

purpose. Indeed, courts have consistently recognized that intending to use tax

savings from a transaction lacking economic substance to underwrite or enhance the

commercial terms of a legitimate business transaction does not constitute a valid

non-tax purpose. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 287;




      14
         (...continued)
the present value of those benefits. Those U.K. tax benefits depended on the vitality
of the trust structure whose economic rationality for BNY depended on BNY
receiving a U.S. foreign tax credit for U.K. tax paid on trust income as the spread
equaled only half of the U.K. tax. Accordingly, Barclays’ U.K. tax benefit could
not be achieved without BNY achieving its U.S. tax benefit.
                                           -46-

see also Am. Elec. Power Co., Inc. v. United States, 

, 744 (6th Cir.

2003) (“Money generated by means of abusive tax deductions can always be

applied to beneficial causes, but the eventual use of the money thus generated is not

part of the economic sham analysis.”).

                             ii. The Loan Was Not Low Cost.

      We now turn to respondent’s contention the loan was not “low cost” absent

the spread. Mr. Cragg compared the loan to available market financing. He opined

that the loan was a secured, highly collateralized loan, cancellable within 5 to 30

days. He further opined that comparable short-term financing, both secured and

unsecured, for a borrower similar to BNY is typically obtained through highly

efficient and standardized interbank relationships at or below an interest rate of 1-

month LIBOR and de minimis transaction costs (market benchmark loan). Absent

the spread adjustment, the loan’s interest rate (LIBOR plus 20 basis points) was

above the market benchmark loan. Beyond the additional interest expense, the loan

required BNY to incur substantial transaction costs in the form of professional

service fees and foreign taxes that would not exist in a comparable market

financing.15 In short, BNY could have obtained comparable financing in the market


      15
           We note that, regardless of how the spread is characterized, the benefit of
                                                                           (continued...)
                                         -47-

place at substantially less economic cost than that obtained through STARS. We

find that the loan was not “low cost.”

      D. Economic Substance of the Integrated STARS Arrangement

      The STARS transaction still lacks economic substance even if the STARS

structure and the loan are evaluated as an integrated transaction. Petitioner contends

that the integrated STARS transaction has objective economic substance because it

offered a reasonable opportunity for pre-tax profit. Petitioner asked its expert Mr.

Atherton to calculate the pre-tax profitability of the STARS transaction. Mr.

Atherton concluded that BNY reasonably could have expected a profit of more than

$1.6 billion before taking into account U.K. or U.S. income taxes over the life of the

STARS transaction.

      We find that Mr. Atherton’s analysis of STARS’ pre-tax profitability contains

several critical flaws and is therefore not helpful to the Court. One such flaw with

Mr. Atherton’s pre-tax profitability calculation is that he includes income from the

STARS assets as revenues arising from the STARS transaction. As we previously

held, the pre-existing cashflows from the trust assets are not incremental to the



      15
        (...continued)
the spread was more than offset by the additional transaction costs that BNY
incurred to obtain the spread.
                                         -48-

STARS transaction and therefore irrelevant to the objective economic substance

analysis.

       Mr. Atherton’s pre-tax profitability analysis is also flawed because he

includes returns on asset-backed securities he assumes BNY contemplated acquiring

with the loan proceeds. Only cashflows arising from the transaction whose

economic substance is at issue are relevant to the pre-tax profitability analysis. See

Nicole Rose Corp. v. Commissioner, 320 F.3d at 284 (rejecting the taxpayer’s

argument that profits from an unrelated asset sale should be attributed to a lease

transaction generating the tax benefits at issue); ACM P’ship v. Commissioner, 157

F.3d at 260 (disregarding profits from funds acquired in a transaction and invested

outside of the structure being evaluated for economic substance); see also Kipnis v.

Commissioner, T.C. Memo. 2012-306 (economic substance should be reviewed

without reference to expected profit from an intended real estate investment that the

taxpayer expected to make with proceeds from the “CARDS” transaction); Long

Term Capital Holdings, 330 F. Supp. 2d at 183 (requirements of economic

substance are not avoided by coupling a routine profitable economic transaction

with no inherent tax benefits to a unique transaction that otherwise lacks profit

potential).
                                          -49-

      Here, the integrated STARS transaction’s net pre-tax effect was to create a

$1.5 billion loan at LIBOR plus 20 basis points. It did not generate any revenue,

only an obligation to repay the loan principal and interest. Any income from

investing the loan proceeds was not a cashflow arising from the integrated STARS

transaction. Rather, it resulted from a separate and distinct transaction. Thus,

income from investing the loan proceeds is not relevant to the economic substance

analysis of the integrated STARS transaction and should have been excluded from

the pre-tax profitability analysis. We note that even if the projected yield on the

loan proceeds Mr. Atherton assumed was relevant that yield is insufficient to offset

the foreign tax costs16 of the transaction.

      The last critical flaw in his analysis is his including the spread in calculating

the cost of the loan, the effect of which is to reduce the cost. As we previously

found, the spread is a tax effect of the STARS structure and its value is effectively

funded by the foreign tax credits. Mr. Atherton therefore should not have reduced

the cost of the loan by the spread in his pre-tax profitability analysis.

      Mr. Atherton’s analysis substantially inflates pre-tax income by including the

non-incremental income from the STARS assets, the projected yield from the loan



      16
           See supra note 9.
                                         -50-

proceeds and the spread as pre-tax income. When these items are omitted, all that

remains is the loan at LIBOR plus 20 basis points. As we previously, discussed,

Mr. Cragg’s analysis shows that the loan was overpriced and therefore not

profitable on a pre-tax basis. Mr. Cragg concluded more generally that it would

have been economically irrational for BNY to enter into the integrated STARS

transaction without the foreign tax credits BNY derived from it. Accordingly, we

find that the integrated STARS transaction lacks economic substance.

      We now address the subjective economic substance of the integrated STARS

transaction. Here, petitioner argues that it was motivated to enter the STARS

transaction to obtain “low cost” financing. As we previously held, we reject that

business purpose because it lacks merit. Aside from that claimed business purpose,

petitioner contends it was motivated to enter into STARS by a realistic expectation

of pre-tax profit. Specifically, petitioner claims that BNY intended to use the loan

proceeds to grow its “investment portfolio” and earn a profit by investing in asset-

backed securities. As we previously held, any income from the investment of the

loan proceeds is not income from the integrated STARS transaction and therefore is

irrelevant to the objective economic substance analysis. Similarly, any profit
                                          -51-

petitioner expected to earn from investing the loan proceeds is not relevant to the

subjective economic substance analysis.17

      E. Congressional Intent

      We now consider whether the disputed tax benefits are what Congress

intended in establishing the foreign tax credit. Petitioner contends that the economic

substance doctrine does not warrant disallowing the disputed tax benefits because

Congress intended the foreign tax credit for transactions like STARS. We disagree.

      The United States taxes income of its citizens, residents and domestic entities

on a worldwide basis. A U.S. corporation must include foreign source income in its

U.S. taxable income even though that income may also be subject to foreign tax.

Congress enacted the foreign tax credit to alleviate double taxation arising from

foreign business operations. See United States v. Goodyear Tire & Rubber Co.,

, 139 (1989); Am. Chicle Co. v. United States, 

, 451

(1942); Burnet v. Chicago Portrait Co., 

, 7 (1932). Congress intended

the foreign tax credit to neutralize the effect of U.S. tax on the business decision of


      17
         We note that petitioner failed to substantiate the claimed business purpose
otherwise. None of the STARS transactional documents or any other persuasive
contemporaneous evidence show that BNY considered investing the loan proceeds
in asset-backed securities. Nor did BNY consider any projected returns from such
an investment in evaluating whether to enter into STARS. And the record does not
reflect that loan proceeds were in fact used to purchase such securities.
                                          -52-

where to conduct business activities most productively. 56 Cong. Rec. App.

677-678 (1918) (statement of Rep. Kitchin). The enactment of the foreign tax credit

was also informed by fairness. See National Foreign Trade Council, Inc.,

International Tax Policy for the 21st Century, (Dec. 15, 2001).

      The STARS transaction was a complicated scheme centered around

arbitraging domestic and foreign tax law inconsistencies. The U.K. taxes at issue

did not arise from any substantive foreign activity. Indeed, they were produced

through pre-arranged circular flows from assets held, controlled and managed within

the United States. We conclude that Congress did not intend to provide foreign tax

credits for transactions such as STARS.

II. Deductibility of STARS-Related Expenses

      We now consider whether petitioner is entitled to deduct expenses incurred

in furtherance of STARS. Petitioner contends that it is entitled to deduct the

claimed transactional expenses and the zero coupon swap interest for 2001 and

2002, and petitioner asks the Court to hold that the U.K. taxes paid on trust

income are deductible if we deny the foreign tax credits claimed for those taxes.

Respondent counters that the claimed transactional expenses and the U.K. taxes
                                        -53-

are not deductible because the STARS transaction lacked economic substance as we

found. We agree.

      Expenses incurred in furtherance of a transaction that is disregarded for a lack

of economic substance are not deductible. See Winn-Dixie Stores, Inc. v.

Commissioner, 113 T.C. at 294 (observing that “a transaction that lacks economic

substance is not recognized for Federal tax purposes” and that “denial of recognition

means that such a transaction cannot be the basis for a deductible expense”); see

also Gerdau Macsteel, Inc. v. Commissioner, 

___ (slip op. at 188). The

claimed transactional expenses, the zero coupon swap interest expense and the U.K.

taxes were all incurred in furtherance of the STARS transaction, which we

previously held lacks economic substance. Consequently, they are not deductible.

III. Foreign Source Income Adjustment

      We next address respondent’s adjustment to BNY’s foreign source income.

Petitioner reported the income from the trust assets as foreign source income based

on a “resourcing” provision in paragraph 3 of article 23 of the Convention for the

Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to

Taxes on Income and Capital Gains, U.S.-U.K., Dec. 31, 1975, 31 U.S.T. 5668

(U.S.-U.K. tax treaty).
                                        -54-

      Petitioner contends that the resourcing provision applies and that

respondent’s foreign source income adjustment was improper. We disagree. U.S.

tax laws and treaties do not recognize sham transactions or transactions that have no

economic substance as valid for tax purposes. Del Commercial Props., Inc. v.

Commissioner, T.C. Memo. 1999-411 (citing Gregory v. Helvering, 

,

470 (1935), and Johansson v. United States, 

, 813 (5th Cir. 1964)),

aff’d, 

 (D.C. Cir. 2001). Because we previously held that the STARS

transaction is disregarded for U.S. tax purposes, BNY is treated for U.S. tax

purposes as owning the STARS assets and the income is treated as being derived by

BNY within the United States. Consequently, the U.S.-U.K. tax treaty, including

the resourcing provision, does not apply. We therefore sustain respondent’s

adjustment of petitioner’s foreign source income.

IV. Conclusion

      In sum, the STARS transaction (bifurcated or integrated) lacks economic

substance and Congress did not otherwise intend to provide foreign tax credits for

transactions such as STARS. Accordingly, the STARS transaction is invalid for

Federal tax purposes and the foreign tax credits and expense deductions claimed in

connection with it are disallowed.
                                        -55-

      We have considered all remaining arguments the parties made and, to the

extent not addressed, we find them to be irrelevant, moot or meritless.

      To reflect the foregoing,


                                               Decision will be entered for

                                       respondent.