In or Out: How to Treat Foreign Taxes Under the Economic Substance Doctrine
In or Out: How to Treat Foreign Taxes Under the Economic Substance Doctrine
Roland Hartung 0 1
0 Washington and Lee University School of Law , USA
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Follow this and additional works at: https://scholarlycommons.law.wlu.edu/wlulr Part of the Comparative and Foreign Law Commons, and the Tax Law Commons Recommended Citation Roland Hartung, In or Out: How to Treat Foreign Taxes Under the Economic Substance Doctrine, 75 Wash. & Lee L. Rev. 1171 (2018), https://scholarlycommons.law.wlu.edu/wlulr/vol75/iss2/10
In or Out: How to Treat Foreign Taxes
Under the Economic Substance
* Juris Doctor candidate at the Washington and Lee School of Law, Class
of 2018. I thank Dean Brant Hellwig for all of his helpful feedback and guidance
while writing this Note. I would also like to thank my parents, Karin and
Wolfgang Hartung, for being a constant source of support. Finally, I would like
to thank Roger Mentz, whose feedback was invaluable in improving this Note
and my understanding of the issue.
VI. Conclusion ...................................................................... 1213
Corporations engage in business transactions for a wide
variety of reasons. Doing so purely to obtain an illegitimate tax
advantage, however, is not permissible.1 Generally, business
transactions ?must serve a bona fide business purpose (i.e., not
just . . . tax avoidance [purposes]) to qualify for beneficial tax
treatment.?2 To determine whether a legitimate business purpose
exists, the Internal Revenue Service (IRS) and the courts look to
the economic substance doctrine.3 The doctrine ?is a common-law
rule that allows courts to question the validity of a transaction and
deny taxpayers benefits to which [they] are technically entitled
under the Code if the transaction at issue lacks ?economic
A circuit split has emerged, however, and the application of
this doctrine has become more complicated, possibly affecting
hundreds of millions of dollars in foreign tax credits. The U.S.
Courts of Appeals for the Federal Circuit5 and the Second Circuit,6
on the one hand, and the Fifth7 and Eighth8 Circuits, on the other,
disagree about how to apply the objective prong of the economic
substance doctrine to disputed transactions.9 Specifically, the
issue is whether foreign income taxes should be included in the
calculation of pre-tax profits when determining if a transaction
has meaningfully altered the taxpayer?s economic position.10
Resolving this issue is crucial, because the economic substance
doctrine functions as the gatekeeper for foreign tax credits.
Depending on the courts? application of the doctrine, taxpayers
may be awarded?or denied?hundreds of millions of dollars in
foreign tax credits. A split amongst the courts leads to
uncertainty for both taxpayers and the government alike.
This Note attempts to resolve this split by suggesting that,
when calculating pre-tax profits under the objective prong of the
economic substance doctrine, foreign income taxes should be
treated as expenses. Part II examines the economic substance
doctrine itself. In this regard, the focus is on the history and
origin, modern conception and use, and recent clarification of the
doctrine into the Internal Revenue Code.11 Part III focuses on the
circuit split. The cases are discussed chronologically, beginning
with the Eighth and Fifth Circuits, followed by the Federal and
Second Circuits. The discussion puts particular emphasis on the
underlying transactions that give rise to the disputes, and the
objective prong of the doctrine.12 Part IV discusses pending
litigation in other jurisdictions, which may have an impact on the
circuit split. Particularly, this Part focuses on the recent opinion
by the First Circuit as a case study and current federal district
7. See generally Compaq Comput. Corp. v. United States, 277 F.3d 778
(5th Cir. 2001).
8. See generally IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir.
9. See Bank of N.Y. Mellon Corp., 801 F.3d at 113 (inquiring whether the
taxpayer?s transaction had a meaningful chance to generate a profit).
10. See id. at 117?18 (concluding that foreign taxes should be considered
expenses when calculating pre-tax profits under the objective prong of the
economic substance doctrine and stating that ?both the Compaq and IES courts
declined to consider the foreign taxes paid and foreign tax credits claimed in
their economic substance analysis?).
11. Infra Part II.
12. Infra Part III.
court litigation.13 Part V recommends that the circuit split be
decided in favor of the Federal and Second Circuits? points of
view, namely that foreign taxes should be treated as expenses
when determining the potential for pre-tax profits. The Part
discusses the reasons for choosing this resolution and the
legislative, regulatory, and judicial options for resolution.14 Part
VI concludes by summarizing the arguments, and offering a
solution for this issue.15
II. The Economic Substance Doctrine
To understand the economic substance doctrine, it is
important to understand in which contexts it applies. Generally,
a taxpayer?s transaction must comply with ?the detailed language
of a tax statute.?16 However, ?at times a court subjects a taxpayer
to . . . [scrutiny] even though the taxpayer complied with the
literal language of the tax statute.?17 In such cases, courts may
look past the exact language of a statute.18 Courts do so by
applying a common law doctrine that has come to be known as
the economic substance doctrine. Yet, the application of the
doctrine has proven not to be straightforward.
A. History and Modern Use of the Economic Substance Doctrine
The history of the economic substance doctrine is difficult to
delineate.19 Other doctrines that courts developed around the
same time are the business purpose doctrine20 and the sham
transaction doctrine.21 On the one hand, the business purpose
doctrine looks into the subjective intent of the taxpayer,
providing ?that a tax statute will not be applied to a transaction
unless the transaction serves some business purpose, other than
tax avoidance.?22 On the other hand, the sham transaction
doctrine focuses on the objective character of the transaction,
namely, inter alia, whether a transaction had a reasonable
chance for profits.23
Arguably, the economic substance doctrine incorporates these
two doctrines.24 This has prompted commentators to note that
these concepts are ?often commingled? and used
interchangeably.25 Nevertheless, the business purpose doctrine,
the sham transaction, and the economic substance doctrine all
originated from the case Helvering v. Gregory26 in 1934.27
In Gregory, Judge Learned Hand laid the foundation for
establishing the economic substance doctrine as it exists today.28
The plaintiff, Mrs. Gregory, aimed to eliminate tax consequences
from the sale of shares of a United Mortgage Corporation (UMC)
subsidiary, of which she was the sole shareholder.29 To achieve
(11th Cir. 2001) (stating that a business purpose exists ?as long as it figures in a
bona fide, profi-seeking business?).
21. See id. (noting that the sham doctrine is synonymous with the economic
substance doctrine, ?provid[ing] that a transaction ceases to merit tax respect
when it has no economic effects other than the creation of tax benefits?).
24. See infra note 80 and accompanying text (combining the two doctrines
by using the word ?and? to express that both elements are needed).
25. See Gillis & Holley, supra note 23, at 176 (describing the doctrines and
providing examples of cases in which the doctrines were applied).
26. 69 F.2d 809 (2d Cir. 1934), aff?d, 293 U.S. 465 (1935).
27. See id. at 810?11 (disallowing tax exemption for the taxpayer?s business
reorganization, made for purely tax reasons, because Congress did not intend for
taxpayers to use the underlying statutory provision in such a way).
28. See Kolarik II & Wlodychak, supra note 16, at 722, 724 (stating that
Judge Hand developed the doctrine ?in his [struggle] to find a workable solution
to the problem of tax avoidance?).
29. See Gregory, 69 F.2d at 810 (?In 1928 it became possible to sell
this, Mrs. Gregory established another corporation through which
she would be able to avoid the tax through corporate
The Commissioner of Internal Revenue rejected Mrs.
Gregory?s tax structure, ?determining that the transaction lacked
substance and was entered into solely for tax avoidance
purposes.?31 Writing for the Second Circuit, Judge Hand agreed
with the Commissioner, concluding that Mrs. Gregory entered
into the reorganization for no other reason but to avoid her
taxes.32 Subsequently, the Supreme Court affirmed the Second
Circuit?s decision, ?finding that Mrs. Gregory?s transaction was in
pursuance of a plan to reduce her taxes which ?[had] no business
purpose,? which it determined to be the prerequisite for corporate
reorganizations.?33 Arguably, Gregory marks the first foray into
what would eventually evolve into part of the economic substance
doctrine.34 Yet, the doctrine?s development progressed slowly.
More than twenty years later, Judge Hand issued a
dissenting opinion in Gilbert v. Commissioner,35 which provided a
more comprehensive formulation of the doctrine.36 In Gilbert, the
Second Circuit determined whether a shareholder advance should
be treated as a loan or a capital contribution.37 The plaintiffs,
Benjamin and Madeline Gilbert, were both involved in Gilbor,
the . . . shares . . . but if this had been done directly, [UMC] would have been
obliged to pay a normal tax on the resulting gain, and . . . a surtax would have
been assessed against [Gregory] personally [for the dividends paid from the
30. See id. at 810 (providing a detailed description of the exact steps and
tax code provisions at issue); see also Monica D. Armstrong, OMG! ESD
Codified!: The Overreaction to Codification of the Economic Substance Doctrine,
9 FLA. A&M UNIV. L. REV. 113, 118?20 (2013) (same).
31. Armstrong, supra note 30, at 120.
32. See Gregory, 69 F.2d at 810 (?To dodge the shareholders? taxes is not
one of the transactions contemplated as corporate ?reorganizations.??).
33. Armstrong, supra note 30, at 121 (quoting Gregory v. Helvering, 293
U.S. 465, 469?70 (1935)).
34. See Gregory v. Helvering, 293 U.S. 465, 469?70 (1935) (describing what
would later become the subjective prong?the business purpose inquiry).
35. 248 F.2d 399 (2d Cir. 1957).
36. See id. at 411 (Hand, J., dissenting) (noting the need for an objective
inquiry into the transaction, and not merely the intent of the taxpayer).
37. See id. at 400 (dealing with the specific question of which principle to
apply to adequately answer the issue).
Inc. (Gilbor), which had been involved in numerous unsuccessful
business ventures.38 Due to these unsuccessful ventures, the
Gilberts made additional investments into Gilbor ?that were
structured as loans.?39 Subsequently, Gilbor liquidated and the
Gilberts ?claimed bad debt deductions on their 1948 joint income
The Commissioner denied the Gilberts? deductions, arguing
that the loans were in fact capital contributions, which would not
have given rise to bad debt deductions.41 The Tax Court agreed
and the Gilberts appealed to the Second Circuit.42 While the
majority decided not to rule and remanded the case for further
proceedings, Judge Hand found strong words in favor of a
substantive approach for analyzing the transaction.43 He argued
that not only must a taxpayer?s business purpose be legitimate and
within the framework of the statute at issue, it must also
?appreciably affect his beneficial interest.?44 This marked one of
the first references to both of the factors of the economic substance
doctrine up to that date. It would be another few years before the
next development on the economic substance doctrine occurred.
In 1960, the Supreme Court of the United States adopted
Judge Hand?s approach from Gilbert in Knetsch v. United States.45
The case ?involve[d] . . . classic . . . tax arbitrage.?46 Knetsch
38. See Kolarik II & Wlodychak, supra note 16, at 736 (noting that
although only Benjamin Gilbert was a shareholder in Gilbor and Madeline was
not, she was still strongly involved in the company).
41. See Gilbert, 248 F.2d at 402 (ruling that the Gilberts? contributions
were not ?bona fide loans? and even though Madeline?s contributions were loans,
they were not within her trade or business).
42. Id. at 410.
43. See id. at 410?12 (providing an inquiry into the taxpayer?s subjective
intent as well as the objective circumstances surrounding the transactions).
44. See id. at 411 (concluding that if a taxpayer?s transaction does not
fulfill these requirements, the tax authorities may disregard the transaction, as
it could not conceivably be the purpose of the tax code to allow taxpayers to
?escape from the liabilities that it sought to impose?).
45. See Knetsch v. United States, 364 U.S. 361, 366 (1960) (finding that
?Kentsch?s [sic] transaction with the insurance company did ?not appreciably
affect his beneficial interest except to reduce his tax?? (quoting Gilbert v.
Comm?r, 248 F.2d 399, 411 (2d Cir. 1957) (Hand, J., dissenting))).
46. Kolarik II & Wlodychak, supra note 16, at 744.
involved complicated transactions concerning debt-financed
single-premium annuities.47 In 1953, the plaintiff, Mr. Knetsch
purchased such an annuity from Sam Houston Life Insurance
Company.48 However, ?the Service discovered that Sam
Houston . . . was marketing the . . . annuity transactions as a tax
shelter strategy and began challenging the transactions.?49 Due
to a circuit split on the issue, the United States Supreme Court
Justice Brennan, writing for the majority, adopted Judge
Hand?s approach set forth in Gilbert.51 He concluded that ?there
was nothing of substance to be realized by Knetsch from this
transaction beyond a tax deduction.?52 While Justice Brennan
explicitly referred to what was arguably the objective economic
substance component, his analysis into the taxpayer?s business
purpose was rather implicit.53 After discussing the individual
steps, Justice Brennan concluded that Knetsch?s transaction was
not aligned with the purpose of the statute and that ?the
transaction was a sham.?54
The cases up to this point constitute the basis for what would
become today?s economic substance doctrine. Judge Hand?s
pursuit to combat tax avoidance schemes in Gregory and Gilbert
47. See Knetsch, 364 U.S. at 362 (involving a series of transactions
surrounding a 30-year maturity deferred annuity savings bond). For the
purposes of this Note, it is not necessary to discuss the detailed steps of these
transactions. See Kolarik II & Wlodychak, supra note 16, at 744 (providing a
step-by-step account of the transactions a taxpayer would enter into to obtain
the desired tax benefits).
48. See Knetsch, 364 U.S. at 362 (?[T]he insurance company sold Knetsch
ten 30-year maturity deferred annuity savings bonds, each in the face amount of
$400,000 . . . .?).
49. Kolarik II & Wlodychak, supra note 16, at 745.
50. See Knetsch, 364 U.S. at 362 (aiming to resolve a split between the
Ninth and Fifth Circuits).
51. See id. at 366 (?Plainly, therefore, [the] transaction with the insurance
company did ?not appreciably affect [Knetsch?s] beneficial interest except to
reduce his tax . . . .?? (quoting Gilbert v. Comm?r, 248 F.2d 399, 411 (2d Cir.
1957) (Hand, J., dissenting))).
53. See id. at 365?66 (engaging in an analysis of ?what was done here,?
namely Knetsch?s intention to generate large insurance payouts).
54. See id. (agreeing with the trial court that Knetsch did not ?intend? to be
indebted to Sam Houston Insurance, but rather was only focused on producing
favorable tax consequences).
led him to conclude that it was necessary to examine, not only the
taxpayer?s mind, but also the transaction itself.55 Eventually, the
Supreme Court agreed, and in Knetsch stated: ?[T]hrough its
adoption of Judge Hand?s Gilbert test, place[d] the economic
substance doctrine in the income tax common law.?56 However,
the economic substance doctrine still did not have a concise
definition. This changed with Frank Lyon Co. v. United States.57
Some commentators regard Frank Lyon as the most
important case in the development of the economic substance
doctrine.58 The case concerned the Frank Lyon Company, a
corporation that attempted to enter into a sale-leaseback
transaction59 with the Worthen Bank & Trust Company
(Worthen).60 Additionally, ?Frank Lyon was Lyon?s majority
shareholder and board chairman; [and] he also served on
Worthen?s board.?61 Worthen planned to construct a new bank
55. See supra notes 19?49 and accompanying text (describing the
individual elements of the doctrine).
Kolarik II & Wlodychak, supra note 16, at 745.
57. See Frank Lyon Co. v. United States, 435 U.S. 561, 582?84 (1978)
(emphasizing both the taxpayer?s motivation and the economic significance of
the transaction for the taxpayer?s business).
58. See Kolarik II & Wlodychak, supra note 16, at 746 (arguing that it was
the case in which the economic substance doctrine was formally adopted); Allen
D. Madison, The Tension Between Textualism and Substance-Over-Form
Doctrines in Tax Law, 43 SANTA CLARA L. REV. 699, 701 (2003) (noting that
Frank Lyon marked the last case in which the Supreme Court applied a
substance-over-form analysis to the merits of a case); Philip Sancilio, Note,
Clarifying (or Is It Codifying?) the ?Notably Abstruse?: Step Transactions,
Economic Substance, and the Tax Code, 113 COLUM. L. REV. 138, 144 (2013)
(describing the Supreme Court?s formulation of the economic substance doctrine
as its ?final (at least as far as the Court was concerned) and distinctive form?).
59. See Frank Lyon, 435 U.S. at 561 (stating that ?petitioner took title to
the building and leased it back to the bank for long-term use?). For a detailed
description of sale-leaseback transactions and their application, see generally
TERREL G. BRESSLER & TYLER C. WILLIBRAND, SALE-LEASEBACK TRANSACTIONS: A
FINANCING ALTERNATIVE FOR MIDDLE MARKET COMPANIES (2011),
60. See Frank Lyon, 435 U.S. at 563 (noting that Worthen was part of the
Federal Reserve System, and was thus subject to the appropriate regulations
applicable to the banks belonging to the system); Kolarik II & Wlodychak, supra
note 16, at 747 (describing the transaction between the two entities as a
61. Frank Lyon, 435 U.S. at 563.
building to replace the existing building, but was unable to do so
due to the Federal Reserve regulations.62 Instead, Worthen
devised a plan to enter into a sale-leaseback transaction, which
the State Bank Department and the Federal Reserve System
ultimately approved.63 Worthen?following the third-party
bidding process and the successful securing of financing from a
third-party insurance company?entered into a sale-leaseback
agreement with Frank Lyon Company.64 Subsequently, ?Worthen
agreed to sell the building to the Frank Lyon Company piece by
piece as Worthen constructed the building for a total price not to
exceed $7.6 million.?65 Because the sale price exceeded the
financing amount by $500,000, the difference ?was effectively an
investment in the building by Frank Lyon Company.?66
On Frank Lyon Company?s federal tax return following the
completion of the building, the company sought to deduct one
month of depreciation on the building, interest on the
construction loan, and various legal and other expenses connected
to the transactions.67 The Internal Revenue Service disallowed
the deductions, stating that because the Frank Lyon Company
did not own the building, it was not entitled to claim these tax
benefits.68 The district court disagreed with the Internal Revenue
Service, reasoning that ?the legal intent of the parties had been to
62. See id. at 564 (elaborating that ?[a]pplicable statutes or regulations
of . . . the Federal Reserve System required Worthen . . . to obtain prior
permission for the investment in banking premises,? which the Federal Reserve
would not approve).
63. See id. at 565 (requiring that ?Worthen possess an option to purchase
the leased property at the end of the 15th year of the lease at a set price,
and . . . that the building be owned by an independent third party?). Although
the price was not to exceed $7.64 million, the building ended up costing over $10
million. Id. at 569.
64. See id. (noting that the financing that Worthen obtained amounted to
65. See Kolarik II & Wlodychak, supra note 16, at 748 (describing the sale
as a series of transactions to be executed over the duration of the construction).
66. See id. (receiving in addition six percent interest on the value of the
67. Frank Lyon Co. v. United States, 435 U.S. 561, 568 (1978).
68. See id. (?All this resulted in a total increase of $497,219.18 over Lyon?s
reported income for 1969, and a deficiency in Lyon?s federal income tax for that
year in the amount of $236,596.36. The Commissioner assessed that amount,
together with interest of $43,790.84, for a total of $280,387.20.?).
create a bona fide sale-and-leaseback in accordance with the form
and language of the documents evidencing the transactions.?69
On appeal, the Eighth Circuit reversed the district court?s
decision, following the IRS?s line of reasoning.70 Analogizing the
ownership for tax purposes to ?a bundle of sticks,? the court
stated that the Frank Lyon Company ?totes an empty bundle of
ownership sticks.?71 The court of appeals concluded that Lyon?s
only economic advantage was income tax savings.72
The United States Supreme Court reversed the Eighth
Circuit?s decision, upholding the deductions.73 The majority, for
which Justice Blackmun wrote the opinion, ?engaged in a
two-step analysis similar to the Gilbert analysis.?74 The majority
reasoned that the appropriate analysis was whether ?there is a
genuine multiple-party transaction with economic substance that
is compelled or encouraged by business or regulatory realities,
that is imbued with tax-independent considerations, and that is
not shaped solely by tax-avoidance features to which meaningless
labels are attached.?75
Applying this test, Justice Blackmun concluded that this was
not the case because: ?Lyon is not a corporation with no purpose
other than to hold title to the bank building,?76 meaning that the
parties? ?collective actions created a sale-leaseback for nontax
From a conceptual perspective, Frank Lyon did not alter
the economic substance doctrine much.78 It was the first time,
however, in which a court described the test in a conjunctive
manner, laying out the elements in their entirety.79 Thus,
based on Frank Lyon, a transaction has economic substance,
provided it passes a two-prong inquiry: ?Was the taxpayer
motivated by no business purpose (other than getting tax
benefits) in entering into the transaction? . . . [And] [d]id the
transaction have objective economic substance, i.e., was there a
reasonable possibility of a profit??80
Following Frank Lyon, ?lower courts drew on the Supreme
Court precedent to formulate many more or less divergent
versions of the economic substance doctrine.?81 While all courts
used the doctrine to one extent or another, the application
differed considerably, creating three basic schools of
application: disjunctive,82 conjunctive,83 and the so-called
77. Kolarik II & Wlodychak, supra note 16, at 750.
78. See id. (arguing that the methodology of the doctrine, namely looking at
the business purpose and objective factors of the transaction, had already been
established in Gregory, Gilbert, and Knetsch).
79. See supra note 75 and accompanying text (using the word ?and? to
combine the subjective and objective element).
80. See Paul Raymond, District Court Upholds Interest Deductions and
Foreign Tax Credits from STARS Transaction, ORANGE CTY. TAX ATT?Y,
http://octaxlawattorney.com/district-court-upholds-interest-deductions-andforeign-tax-credits-from-stars-transaction/ (last visited Apr. 14, 2018)
(constituting the subjective prong and the objective prong, respectively (citing
Frank Lyon Co. v. United States, 435 U.S. 561 (1978))) (on file with the
Washington and Lee Law Review).
81. See Sancilio, supra note 58, at 144 n.29 (noting that the Supreme Court
never explicitly labeled the prongs as the economic substance doctrine, and that
other courts have often used the term interchangeably with the term ?sham
doctrine? and other tax avoidance doctrines).
82. See ACM P?ship v. Comm?r, 157 F.3d 231, 247 (3d Cir. 1998)
(?However, these distinct aspects of the economic sham inquiry do not constitute
discrete prongs of a ?rigid two-step analysis,? but rather represent related factors
both of which inform the analysis of whether the transaction had sufficient
substance, apart from its tax consequences, to be respected for tax purposes.?).
83. See Rice?s Toyota World, Inc. v. Comm?r, 752 F.2d 89, 91
(4th Cir. 1985)
(?To treat a transaction as a sham, court must find that the taxpayer was
motivated by no business purposes other than obtaining tax benefits in entering
the transaction, and that the transaction has no economic substance because no
?flexible inquiry.?84 The increasing uncertainty and the emerging
circuit splits prompted Congress to act.
B. Clarification of the Economic Substance Doctrine
In 2010, ?[a]s part of the Health Care and Education
Reconciliation Act of 2010 . . . Congress enacted new Section
7701(o), which provides for the ?codification? of the economic
substance doctrine and the addition of substantial penalties for
transactions that are found to lack economic substance.?85 This
?codification? was met with stark resistance.86 As a compromise,
the section was implemented into the tax code not as a
?codification,? but rather as a ?clarification.?87
Prior to 2010, courts disagreed about how to apply the
subjective and objective prongs of the doctrine.88 The
?clarification? of the economic substance doctrine specified that a
transaction must satisfy both prongs to have economic
reasonable possibility of a profit exists.? (emphasis added)).
84. See Bank of N.Y. Mellon Corp. v. Comm?r, 801 F.3d 104, 115
(?In our Circuit the test is not a rigid two-step process with discrete
prongs; rather, we employ a ?flexible? analysis where both prongs are factors to
consider in the overall inquiry into a transaction?s practical economic effects.?).
85. Lipton, ?Codification? of the Economic Substance Doctrine, supra note
3, at 1037. The main impetus for this codification, and especially the new strict
liability penalties, was to provide for an additional revenue booster to finance
the Affordable Care Act (ACA). Initially, the estimated revenue was calculated
to be $17.5 billion. Id.
86. See id. (noting that the administration opposed the codification ?out of
concern that the proposal would reduce the courts? ability to use the economic
substance doctrine to address taxpayer abuses?).
87. See 26 U.S.C. ? 7701(o) (2012) (describing the subsection as a
?clarification? in the heading, rather than a ?codification?); Lipton,
?Codification? of the Economic Substance Doctrine, supra note 3, at 1037 (same);
Charlene D. Luke, The Relevance Games: Congress?s Choices for Economic
Substance Gamemakers, 66 TAX LAW. 551, 551 n.2 (2013) (arguing that the
?codification of the economic substance doctrine was among the most
controversial tax items contained in the health care legislation?).
88. Compare Rice?s Toyota World, Inc., 752 F.2d at 96 (allowing an interest
deduction where the transaction was purely tax motivated but had an element
of economic substance), with United Parcel Serv. of Am., Inc. v. Comm?r, 254
F.3d 1014, 1018 (11th Cir. 2001) (stating that ?[e]ven if the transaction has
economic effects, it must be disregarded if it has no business purpose and its
motive is tax avoidance? (citations omitted)).
substance.89 In other words, courts interpret the economic
substance doctrine as a conjunctive two-part test. This alleviated
much confusion and disparate treatment, and is arguably in line
with the original concept of the economic substance doctrine as
envisioned under Frank Lyon.90
While this was the main issue Congress addressed in the
clarification, it was not the only one. In addition to mandating a
conjunctive analysis, Congress added more elements to the
clarification.91 For the purposes of this Note, the key clarification
applies to the treatment of fees and foreign taxes.92 To fully
understand this subsection, scrutiny of the text of the subsection
and an analysis of the legislative history is crucial.
Subsection 7701(o)(2)(B) is split into two sentences; the first
deals with fees and other transaction expenses, and the second
deals exclusively with foreign taxes.93
The first sentence is styled in the form of a command, leaving
no possibility for deviation.94 Although the second sentence,
concerning foreign taxes, seems equally definitive at first glance,
closer examination reveals that it is not.95 The second sentence,
similarly to the first, stipulates that foreign taxes ?shall? be
treated as expenses.96 Unlike the first sentence, the second
89. See 26 U.S.C. ? 7701(o) (stating that a transaction has economic
substance ?only if? the first ?and? the second prong are fulfilled).
90. Supra notes 75, 79 and accompanying text.
91. See generally THOMAS E. TAYLOR, CODIFICATION OF THE ECONOMIC
SUBSTANCE DOCTRINE BY THE HEALTH CARE AFFORDABILITY RECONCILIATION ACT
OF 2010 (2010), https://www.mcguirewoods.com/news-resources/publications/
taxation/Economic%20Substance%20Codification.pdf (listing additional
elements, including the treatment of state and local taxes, certain financial
accounting benefits, application to individuals, and a reference to penalties).
92. See generally 26 U.S.C. ? 7701(o)(2)(B).
93. See id. (?Fees and other transaction expenses shall be taken into
account as expenses in determining pre-tax profit under subparagraph (A). The
Secretary shall issue regulations requiring foreign taxes to be treated as
expenses in determining pre-tax profit in appropriate cases.?).
94. See id. (using the word ?shall? to describe the mandatory nature of the
clause); Shall, MERRIAM-WEBSTER,
https://www.merriamwebster.com/dictionary/shall (last visited Feb. 9, 2017) (describing that the word
?shall? is ?used in laws, regulations, or directives to express what is mandatory?)
(on file with the Washington and Lee Law Review).
95. See 26 U.S.C. ? 7701(o)(2)(B) (2012) (using various qualifiers which
must be fulfilled before the provision can come into effect).
sentence only applies once the Secretary of the Treasury issues
regulations on the matter ?in appropriate circumstances.?97
Neither the subsection itself, nor the notes of the Joint
Committee on Taxation on the clarification of the economic
substance doctrine, provide any guidance regarding the term
?appropriate circumstances,? or which taxes the provision
From a structural point of view, it is reasonable to assume
that it was not Congress?s intention to stipulate a rigorous rule
regarding foreign taxes. Had Congress intended to do so, it could
have simply included foreign taxes within the first sentence,
leaving no room for doubt. Yet, Congress chose to separate
foreign taxes, requiring administrative action limited to certain
While the Joint Committee on Taxation?s General
Explanation of Tax Legislation does not provide any guidance on
the term ?appropriate circumstances,? it does provide limited
guidance on the legislative intent behind the clause. In their
explanation of the clause, the committee notes that ?[t]here is no
intention to restrict the ability of the courts to consider the
appropriate treatment of foreign taxes in particular cases, as
under present law.?100 This statement supports a less rigorous
reading of the second sentence of ? 7701(o)(2)(B). As in the
subsection itself, the legislative intent makes use of the qualifiers
?in particular cases,? and ?under present law.?101 Again, the
committee provides no guidance on what these two terms entail.
The most important part of the statement is the intention to
provide deference to the courts to determine their own treatment
of foreign taxes when calculating pre-tax profits.102 This phrase
provides a clear indication that Congress did not intend to take
authority from the courts regarding the treatment of foreign
98. See generally id.; JOINT COMM. ON TAX., 111TH CONG., GENERAL
EXPLANATION OF TAX LEGISLATION, JCS?2?11 (Comm. Print. 2011). The author
was unable to locate any other source discussing the doctrine.
99. 26 U.S.C. ? 7701(o)(2)(B).
100. JOINT COMM. ON TAX., supra note 98, at 381 n.1047.
102. See id. (referring specifically to ?the ability of the courts to consider the
appropriate treatment of foreign taxes?).
taxes when calculating pre-tax profits, allowing courts to apply
their own treatment.
The practical realities surrounding this clause support this
reading of the subsection, as well as the legislative intent. The
Secretary of the Treasury has not issued any such regulation.103
Thus, based on this ambiguity and administrative inaction, a
split between the circuits? treatment of foreign taxes regarding
the calculation of pre-tax profits remains.104
III. The Circuit Split: Should Foreign Taxes Be Included in the
Calculation of Pre-Tax Profits?
The split between the courts arises from a disagreement over
the framework of the objective prong of the economic substance
inquiry.105 Specifically, the issue is whether foreign taxes should
be included in the calculation of pre-tax profits when determining
if a transaction has meaningfully altered the taxpayer?s economic
position.106 On both sides of the split, the issue commonly arises
in the context of cross-border securities transactions, specifically
whether these transactions are purely tax motivated.107 As
mentioned, a resolution to this issue is crucial, as the
interpretation of the objective prong of the economic substance
doctrine determines whether taxpayers will receive hundreds of
millions of dollars in foreign tax credits.108
A. The Eighth Circuit: IES Industries, Inc. v. United States
The Eighth Circuit decision in IES Industries, Inc. v. United
States109 is chronologically the first decision in the split.110 The
case revolved around the IRS?s denial of a tax refund to the
taxpayer, IES.111 The transactions at hand involved American
Depository Receipts (ADRs).112 Owners of such receipts are
?entitled to all dividends and capital gains associated with the
ADR, with those moneys taxable in the home country of the
foreign corporation.?113 The owner is entitled to the dividend as of
the ?record date.?114
Generally, the foreign corporation withholds the foreign tax
due on such dividends before they are transferred to the U.S.
taxpayer.115 In this case, the applicable withholding rate was
fifteen percent.116 The result was that ?the record owner is
entitled to a 15% foreign tax credit, a dollar-for-dollar credit
against U.S. taxes owed.?117 IES used a securities advisor to
identify corporations to invest in.118 Upon choosing a corporation,
109. 253 F.3d 350 (8th Cir. 2001).
110. See id. at 350 (publishing the final decision on June 14, 2001).
Discussing the cases chronologically is crucial, as the cases build upon and
reference each other.
111. See id. at 351 (disallowing the tax refund at both the initial refund and
district court stage because the transactions were ?sham transactions?).
112. See id. (?ADRs are publicly traded securities, or receipts, fully
negotiable in U.S. dollars, that represent shares of a foreign corporation held in
trust by a U.S. bank.?).
114. See Record Date, INVESTOPEDIA, http://www.investopedia.com/terms/r/
recorddate.asp?lgl=no-infinite (last visited Apr. 26, 2018) (describing ?the cut-off
date established by a company in order to determine which shareholders are
eligible to receive a dividend or distribution?) (on file with the Washington and
Lee Law Review); see also IES Indus., Inc., 253 F.3d at 351 (noting that the
record date and the actual payment date may be several weeks apart).
115. See IES Indus., Inc., 253 F.3d at 351 (noting that in this case, the
foreign corporations which paid the tax were situated ?in the United Kingdom,
the Netherlands, and Norway?).
116. See id. (?[T]he record owner of the ADR would receive 85% of the
dividend in cash, but the gross income?100% of the dividend?would be fully
taxable in the United States.?).
118. See id. at 352 (noting that the securities firm chose companies which
had announced a dividend).
?IES purchased ADRs with a[n] . . . effective trade date, before
the record date for the dividend, so that IES was the owner on the
record date and therefore entitled to be paid the dividend.?119
Immediately after the purchase, IES sold the ADRs so the
effective trade date of the sale was after the record date.120 In
other words, IES bought the stock, including the right to the
dividends, and immediately sold it without dividends, resulting in
a capital loss.121
Despite the capital loss, IES still generated a profit due to
the dividends.122 This meant ?IES retained the dividends, which
were ordinary income to the company, paid the 15% foreign tax,
and therefore claimed a 15% foreign tax credit in the United
States.?123 The IRS, as well as the district court, disallowed the
foreign tax credit, deductions for half of the foreign tax, and other
On appeal, the Eighth Circuit applied both prongs of the
economic substance doctrine to determine whether IES?s strategy
passed muster.125 In the court?s view, a transaction constituted a
sham if ??it [was] not motivated by any economic purpose outside
of tax considerations? (the business purpose test), and if it ?is
without economic substance because no real potential for profit
120. See id. (?The purchase and sale generally took place within hours of
each other, and sometimes in Amsterdam when the U.S. and European markets
121. See id. (describing the purchase as ?cum-dividend? and the sale as
See id. at 352 (stating that the dividend income exceeded the capital
124. See id. at 353 (arguing the transactions were a sham and that they had
no purpose or effect beyond tax).
125. See id. at 353?56 (applying both prongs despite declining to decide
whether both prongs must be fulfilled to establish economic substance).
Regarding the subjective prong of the economic substance doctrine, the court
concluded that the transactions occurred at an arm?s length basis under normal
market conditions, and that normal market risks were involved. See id. at 355
(referring to the government?s argument that the transactions were a sham
because they involved no risk). The court noted that ?[t]he legal right of a
taxpayer to decrease the amount of what otherwise would be his taxes, or
altogether avoid them, by means which the law permits, cannot be doubted.? Id.
(citations omitted). Thus, the court concluded that IES had a legitimate
business purpose for entering into the ADR transactions.
exists? (the economic substance test).?126 In both instances the
court stated that the transactions fulfilled the test.127
The most important aspect of the case appears in the Eighth
Circuit?s discussion of the objective element of the test?the
economic substance prong. The government argued that the
economic benefit of a transaction should be measured based on
the net dividend, after deducting the foreign tax, rather than the
gross dividend.128 The result was that ?the government
would . . . regard only 85% of the dividends as income to IES,
notwithstanding that the IRS treats 100% as income for tax
The Eighth Circuit rejected this view and ruled that the
economic benefit to IES should be assessed on the basis of gross
dividends.130 The fact that ?IES received only 85% of the dividend
in cash, is of no consequence to IES?s liability for the tax.?131
Therefore, IES received an economic benefit from the
transactions regardless of whether the foreign tax was
deducted.132 Based on this reasoning, the Eighth Circuit
dismissed the IRS?s claims, deciding that the transactions
fulfilled both elements of the economic substance test.133
126. See id. at 353 (describing the business purpose test as the subjective
part, and the economic substance test as the objective part of the greater
economic substance analysis (quoting Shriver v. Comm?r, 899 F.2d 724, 725?26
(8th Cir. 1990))).
127. See id. at 354 (applying a more in-depth review of the facts than the
district court, the Eighth Circuit noted that ?the ADR trades here had both
economic substance and a business purpose?).
128. See id. (noting that under that approach ?benefit accrues to IES only if
it receives the foreign tax credit?).
130. See id. (stating that because IES was the legal owner of the dividends
on the record date, the entire amount due on that date was considered income).
132. See id. (concluding that under this approach the transactions resulted
in a net profit).
133. See id. at 359 (reversing the district court?s findings and remanding for
components?a trust and a loan.155 BB&T created the trust and
contributed a large amount of ?income-generating assets.?156
BB&T then entered into a loan agreement that ?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.?157 Yet, even though Barclays held an equity interest in
the trust, BB&T retained control over the trust at all times.158 To
create the cross-border element, BB&T appointed a U.K. trustee
to manage the trust.159 The income generated from the assets
would be paid to the trust, which would withhold the U.K. taxes,
followed by a temporary transfer to a Barclays account before
being transferred directly back to the trust.160 This resulted in ?a
substantial tax benefit for Barclays by allowing it to claim a
?trading loss deduction? under U.K. law.?161 BB&T?s and
Barclays?s tax benefits also resulted from the so-called ?Bx
payments.?162 These payments ?[were] 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.?163 Together, the transaction created substantial tax
benefits for both companies.164
The Federal Circuit used a simplified example to illustrate
the benefits of the transactions.165 The court stated that ?$22 for
155. See id. at 937 (describing the trust as the primary vehicle and the loan
as the mechanism for achieving the tax benefits). The term ?Bx payment? is a
term created by BB&T.
156. See id. at 937, 951 (valuing the contributed assets at approximately
$5.8 billion and noting that these assets in fact created ?legitimate income?).
157. Id. at 937.
158. See id. (noting that ?Barclays was contractually obligated to sell? the
$1.5 billion interest back to BB&T once the transactions concluded, which would
be categorized as a loan).
159. See id. (explaining that the trustee?s U.K. residence triggered the U.K.
tax liability, which would ultimately lead to the foreign tax credit).
160. See id. (creating a ?circular movement? of funds between the trust and
162. See id. at 937?38 (describing the payments as another avenue through
which BB&T and Barclays reduced their tax liability).
163. Id. at 938.
164. See id. (amounting, in total, ?to foreign tax credits in the amount of
165. See id. (framing the tax consequences in terms of ?$100 of Trust
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,? for
which it would later receive a tax credit.166 Moreover, because
Barclays held an equity interest in the Trust, Barclays was also
subject to U.K. taxation on the same income.167 However,
Barclays was able to offset the Trust?s tax burden, resulting in an
effective tax rate of $8 per every $100 of Trust income.168
The ?circular movement? between the Trust and Barclays
provided an additional tax benefit.169 The result was that
?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.?170 Barclays then added another $3.30 of tax benefits
based on the Bx payments.171 BB&T received a tax benefit by
claiming a tax credit for the U.K. tax paid on the Trust income.172
In total, ?BB&T anticipated receiving approximately $44 million
per year from the STARS Trust transaction in addition to the
revenue generated by the assets themselves.?173 Yet, the success
of the STARS transactions depended on the favorable assessment
by the tax authorities.174
166. See id. (basing those figures on the twenty-two percent tax rate which
the U.K. levied on the Trust income).
167. See id. (subjecting Barclays to a tax of $30 on every $100 based on the
30% U.K. corporate tax rate).
168. See id. (claiming an ?imputation credit? for the $22 of tax already paid
by the Trust under UK law).
169. See id. (moving the remaining $78 of income from the Trust to Barclays
and back, resulting in a ?trading loss? for Barclays for which it was able to claim
a $23.40 deduction).
171. See id. (?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).?).
172. See id. (explaining that BB&T would receive a dollar-for-dollar credit
for the $22 of taxes paid to the UK, in addition to the $11 BB&T gained through
the Bx payment).
174. See id. at 939 (acknowledging that both parties knew of these risks, and
thus included additional agreements under which BB&T agreed to indemnify
Barclays should the projected profits fail ?to match the parties? expectations?).
The Federal Circuit stated that to determine whether BB&T
should receive the refund, the transaction required an analysis
under the economic substance doctrine.175 Thus, a cumulative
inquiry was necessary, namely that the transaction must fulfill
both the objective and the subjective prongs of the doctrine.176
The court focused its analysis on the objective prong of the
doctrine.177 The court examined the economic reality of the
transaction.178 The inquiry focuses ?on whether the taxpayer had
a ?reasonable possibility of making a profit from the
transaction.??179 The court in Salem Financial, Inc. v. United
States180 examined three questions in this regard, of which the
first two provide the basis for the third.181
First, BB&T disputed the government?s claim that the Bx
payments were, in fact, rebates of the U.K. tax.182 The court
rejected BB&T?s argument, stating that the payments were ?not
truly independent.?183 Second, BB&T argued that the Bx
175. See id. at 940 (agreeing with the Third and Eleventh Circuit that
?economic substance is a prerequisite to the application of any Code provision
allowing deductions? (citations omitted)).
176. See id. (arguing that in order to determine whether a transaction was
genuine or a sham, ?the court examines the economic reality and business
purpose of the transaction? (citing Stobie Creek Invs. LLC v. United States, 608
F.3d 1366, 1375
(Fed. Cir. 2010)
177. Id. at 943. Regarding the subjective prong, the court ultimately
concluded that the transaction had no bona fide business purpose, because
BB&T ?knew that the transaction revolved solely around a tax benefit because
Barclays represented the transactions as creating a benefit from the ability of
both parties to obtain credits for the taxes paid in the Trust.? See id. at 952
(referring to BB&T?s chief financial officer?s statement describing the expected
benefit in terms of tax benefits).
178. See id. at 943 (framing the question of economic reality as ?whether a
particular transaction or set of transactions meaningfully altered the taxpayer?s
economic position, apart from their tax consequences? (citing Stobie Creek Invs.
LLC v. United States, 608 F.3d 1366, 1375
(Fed. Cir. 2010)
179. Id. (quoting Stobie Creek Invs. LLC v. United States, 608 F.3d 1366,
(Fed. Cir. 2010)
182. See Salem Fin., Inc., 786 F.3d at 943 (claiming that because the
payments were ?independent of Barclays? actual receipt of any U.K. tax
benefits,? they should be treated as income).
183. See id. at 943?44 (?BB&T?s ability to benefit economically from the Bx
payments depended on Barclays? receipt of its expected tax benefits, which in
turn depended on the Trust?s U.K. tax payments.?).
payments should nevertheless be treated as income.184 The court
agreed with BB&T, rejecting the government?s argument that the
payments were merely tax effects because the amounts were
calculated through a tax-based formula.185 Third, the government
argued that even if the Bx payments were treated as income,
BB&T did not generate any profit ?absent the foreign tax credit
because the Bx payments must be offset against the Trust?s U.K.
taxes.?186 Conversely, BB&T contended that the government
erred in treating the U.K. taxes as an item of expense rather than
income.187 Ultimately, the Federal Circuit agreed with the
government, stating that ?a transaction?s economic reality, and in
particular its profit potential, [must be] independent of the
expected tax benefits.?188
The court?s reasoning revolved primarily around BB&T?s
reliance on Compaq and IES.189 Upon examining the facts and
reasoning of those cases, the Federal Circuit expressly declined to
follow those holdings.190 Specifically, the court noted that ?the
fact that the transactions produced a net gain to the taxpayer
after taking both the foreign taxes and the foreign tax credit into
account says nothing about the economic reality of the
transactions.?191 Rather, transactions must have real economic
185. See id. at 946 (arguing that the government provided no authority to
support its claim and that the claim was at odds with the principles established
in Old Colony).
186. See id. at 947 (claiming that the ?[t]rust transaction produced a net loss
and therefore lacked economic substance,? because ?for every $100 of income
from the Trust assets, even if BB&T were credited with $11 income in the form
of the Bx payment, that $11 would have to be offset against BB&T?s $22 U.K.
tax expense, which would yield a loss of $11?).
187. See id. at 947?48 (relying primarily on the Fifth and Eighth Circuits?
reasoning in Compaq and IES, namely that potential for economic profit must
be determined based on gross profit).
188. See id. at 948?49 (ruling that ?[t]he Trust transaction . . . is profitless
before taking into account BB&T?s expected foreign tax credits?).
189. See id. at 947?51 (examining in detail the facts involved and the Fifth
and Eighth Circuits? reasoning).
190. See id. at 948 (holding that the Fifth and Eighth Circuits? conclusion
was incorrect and that the transactions at issue in those cases produced ?no real
191. See id. (explaining that ?all tax shelter transactions produce a gain for
the taxpayer after the tax effects are taken into account? and that this is the
effects apart from both taxes paid and tax credits received.192
Thus, the transactions had ?no realistic prospect of producing a
profit (apart from the effect of the foreign tax credits).?193 This
effectively meant that the transaction had no independent
economic characteristics apart from the tax consequences.
D. Second Circuit: Bank of New York Mellon Corporation v.
The Second Circuit issued another decision rejecting the
Fifth and Eighth Circuit holdings nearly fifteen years later.194
The case involved two consolidated appeals.195 The facts of these
cases are complex, but the essential information is as follows.196
In the first case on appeal, the American International Group
(AIG) engaged in six cross-border transactions.197 AIG established
a special purpose vehicle (SPV) to facilitate the transactions.198
Initially, AIG created and funded a foreign SPV.199 Subsequently,
?AIG . . . 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.?200 This meant that the
SPVs consisted primarily of a small contribution from AIG and
primary reason why companies are willing to enter into such transactions at
192. See id. at 949 (ensuring such benefits only if ?there is a genuine
multi-party transaction? that has real business considerations (quoting Frank
Lyon Co. v. United States, 435 U.S. 561, 583?84 (1978))).
193. See id. at 951 (agreeing with the trial court that ?the income ?from
BB&T?s preexisting assets cycled through the STARS Trust was not [economic]
profit from STARS?? (citations omitted)).
194. Bank of N.Y. Mellon Corp. v. Comm?r, 801 F.3d 104, 104
(2d Cir. 2015)
195. See id. at 107 (involving AIG in one case, and the Bank of New York
Mellon in the other).
196. Id. For a detailed description of the two underlying cases, see, e.g.,
Lipton, BNY and AIG, supra note 153, at 41?46.
197. See Bank of N.Y. Mellon Corp., 801 F.3d at 104 (appealing a denial of a
tax refund of $306.1 million).
198. See id. at 108 (noting that the SPV ?borrowed funds at economically
favorable rates below [market] and invested the funds at rates above [market],
ostensibly to make a profit?).
199. See id. (intending the SPV ?to hold and invest funds in a foreign
funds the foreign bank paid for the stock.201 Finally, ?[t]he 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.?202
Contrary to the finding of the lower court, AIG claimed the
transactions had economic substance because AIG expected a
pre-tax profit.203 However, to generate a pre-tax profit, AIG
ignored the foreign tax paid by the SPV and the value of AIG?s
foreign tax credit.204
In the second case, the Bank of New York Mellon (BNY)
entered into a STARS transaction offered by Barclays.205 To
simplify the complicated STARS transaction, the Second Circuit
provided the following illustration:
The resulting tax benefits to both BNY and Barclays from
STARS can be illustrated by tracing a hypothetical $100 of
trust income through the distribution cycle . . . . Under U.K.
tax law, Barclays?as owner of [a certain] class [of
stock] . . . was deemed the owner of almost all of the trust
income and taxed at the 30% U.K. corporate tax rate,
obligating it to pay $30 in tax for every $100 of trust income
($100 x 30%). Barclays would reduce this tax bill, however, by
claiming a credit for the 22% U.K. tax on the trust, which was
paid by BNY. Barclays? tax liability for the trust income was
thus only $8 ($30?$22). BNY, in turn, would claim a foreign
tax credit in the United States for the full $22 it had paid in
U.K. taxes on the trust?s income.206
Based on these facts, the tax court disregarded the STARS
transaction for tax purposes, considering foreign taxes paid as an
203. See id. at 109 (noting that the profit was for the life of the
204. See id. (?[S]ubtracting only AIG?s operating expenses and obligations to
205. For a detailed description of this highly convoluted transaction, see
generally Bank of N.Y. Mellon Corp. v. Comm?r, 140 T.C. 15 (2013).
206. Bank of N.Y. Mellon Corp. v. Comm?r, 801 F.3d 104, 111
(2d Cir. 2015)
expense in determining the economic reality of the
After describing the facts of these two cases, the Second
Circuit set out the applicable law.208 The court considered ?1)
whether the taxpayer had an objectively reasonable expectation
of profit, apart from tax benefits, from the transaction; and 2)
whether the taxpayer had a subjective non-tax business purpose
in entering the transaction.?209 While the Court acknowledged
that it was not bound by the Internal Revenue Code amendment
mandating the evaluation of both prongs, it ultimately discussed
Most of the court?s analysis focuses on the objective prong of
the economic substance test.211 At the heart of the discussion was
?[t]he question . . . [of] whether, for purposes of the economic
substance doctrine, foreign taxes should be treated as costs when
calculating pre-tax profit.?212 Ultimately, the Second Circuit
decided to follow the Tax Court and Salem.213 The Second Circuit
quoted the Tax Court, stating that the foreign taxes cannot be
observed in isolation: ?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 . . . the foreign taxes giving rise to the foreign tax credits
207. See id. at 112 (noting that the transaction also failed under the
208. See id. at 113?19 (stating that the economic substance doctrine applies
to foreign tax credit regimes).
209. Id. at 115 (citing Gilman v. Comm?r, 933 F.2d 143, 147?48 (2d Cir.
210. See id. at 114 (arguing that the court was not bound because the
amendment was passed after the facts of the cases occurred).
211. See id. at 115?22 (discussing thoroughly the approaches of other courts
in delineating its own test). The Second Circuit devoted very little of its opinion
to the subjective prong. See id. at 119?23 (allocating only one paragraph to
describing the standard and its application to the cases respectively). The
Second Circuit agreed with the lower courts that the transactions were purely
tax motivated, concluding that BNY?s transactions ?lacked a reasonable
relationship? to any stated business purpose. See id. at 120?23 (describing
additionally AIG?s transactions as ?tax driven? and ?tax based?).
212. Id. at 116.
213. See id. (?The purpose of calculating pre-tax profit is to discern, as a
matter of law, whether a transaction meaningfully alters a taxpayer?s economic
position other than with respect to tax consequences.?).
stemmed from economically meaningless activity . . . .?214 In other
words, the foreign taxes are intrinsically linked to credits they
create?or, rather, the tax benefit the taxpayer is trying to
achieve?and are thus taken into account as expenses for the
calculation of pre-tax profits.
Not only did the Second Circuit agree with the lower court
and the Federal Circuit, but it also discussed and subsequently
declined to follow the Fifth and Eight Circuits.215 The court ruled
?foreign taxes are economic costs for purposes of the economic
substance doctrine and thus should be deducted from profit before
calculating pre-tax profit.?216 Based on this test, the court
concluded that the transactions in dispute failed the objective
Based on these four cases, the circuits are split on one
distinct issue: Should foreign income taxes paid be taken into
account when calculating pre-tax profits for the purposes of the
objective prong of the economic substance doctrine? The Fifth and
Eighth Circuits take the position that foreign taxes should be
included in calculating pre-tax profits.218 Thus, the possibility for
pre-tax profit was based on gross revenue, rather than net
revenue.219 They argued that to decline the taxpayer this
interpretation was to ?stack the deck? against him.220
The Federal and Second Circuit declined to follow this
approach.221 The Circuits concluded that foreign taxes are similar
to any other transaction cost and should not be seen as ?income?
for the purposes of determining pre-tax profits.222 Thus, a clear
214. Id. at 117.
215. See id. at 118 (concluding that it is appropriate to consider the effect of
foreign taxes, but not the corresponding credit in assessing pre-tax profit).
216. Id. at 119.
217. See id. at 120?21 (noting that for AIG?s foreign tax credit ?far exceeded?
the potential for an economic benefit and that BNY?s transaction provided no
?reasonable opportunity for economic profit?).
218. See supra notes 110?149 and accompanying text (concluding that the
transactions were bona fide).
219. Supra note 130 and accompanying text.
220. See supra note 146 and accompanying text (noting that either all, or
none of the tax benefits should be considered).
221. See supra notes 190, 215 and accompanying text (determining that
foreign taxes should be treated as expenses).
222. See supra note 214 and accompanying text (agreeing with the tax court
dichotomy exists in the application of the doctrine between the
four circuits. This split brings uncertainty to the economic
substance doctrine, and thus a solution is necessary, especially
considering current and emerging cases on the issue.
IV. Litigation in Other Jurisdictions
A. A Case Study: The Recent First Circuit Decision:
Santander Holdings USA, Inc. v. United States
While the recent First Circuit decision223 would be
adequately placed within Part III of this Note dealing with the
circuit split, it provides a perfect case study when comparing it to
the lower court?s decision.224 Specifically, as the First Circuit
ultimately rejected the district court?s ruling.225 The cases are
particularly intriguing because they provide insight into the
arguments of both sides of the split as applied to the same
The factual circumstances of the cases are substantially
similar to both Salem and Bank of N.Y. Mellon Corp. v. United
States227 (BNY), concerning a STARS transaction in which the
taxpayer?in this case Santander Holdings Corp., formerly
known as Sovereign228?entered into with Barclays Bank PLC in
the UK.229 The Internal Revenue Service disallowed the foreign
that because foreign taxes were a prerequisite to the foreign tax credits, they
should be excluded).
223. See generally Santander Holdings USA, Inc. v. United States, 844 F.3d
(1st Cir. 2016)
224. See generally Santander Holdings USA, Inc. v. United States,
144 F. Supp. 3d 239 (D. Mass. 2015), rev?d, 844 F.3d 15
(1st Cir. 2016)
225. Compare Santander, 144 F. Supp. 3d at 240?41 (rejecting the claim
that foreign taxes paid are tax effects and that they should be included in
calculating pre-tax revenue), with Santander, 844 F.3d at 21?26 (reversing the
district court decision and agreeing with the analysis of the Federal and Second
Circuit, namely that foreign income taxes paid should not be include in the
calculation of pre-tax profits).
226. Supra notes 223?224 and accompanying text.
227. 801 F.3d 104, 117?18
(2d Cir. 2015)
228. See Santander, 844 F.3d at 17 (having acquired Sovereign, Santander
became the plaintiff in this line of cases).
229. See generally Santander, 144 F. Supp. 3d at 240. At this point, it is not
necessary to repeat the simplified structure of STARS transactions once again.
tax credit that resulted in ?$234 million in [additional] federal
income taxes, penalties, and interest . . . for the tax years 2003,
2004, and 2005.?230
Beginning its analysis with the objective prong of the
economic substance doctrine, the district court focused on
?whether the ?Barclays payment? (also known as the ?[B]x
payment?) should be accounted for as revenue to Sovereign in
assessing whether Sovereign had a reasonable prospect of profit
in what the parties refer to as the ?trust transaction.??231 The
court ?agreed with Sovereign that the Barclays payment should
be accounted for as pretax revenue, which meant that the trust
transaction showed a reasonable prospect of profit and therefore
did not, as the government had argued, lack economic
The district court split its analysis into two sections: the loan
portion of the STARS transactions and the trust portion of the
STARS transactions.233 In terms of the loan, the court concluded
that even though the loan was above market rate, this did not
mean it lacked economic substance.234
Turning to the trust transaction, the district court rejected
the claim that the transaction lacked economic substance.235 The
court?s reasoning relied primarily on the fact that the assets that
Santander placed into the trust ?were earning income and
Sovereign was being taxed on that income before the STARS
transaction.?236 Additionally, the court noted that Santander?s
For the essential components of STARS, see supra notes 152?174 and
230. Santander, 144 F. Supp. 3d at 240.
231. Id. at 241.
232. See id. (rejecting specifically the argument ?that the Barclays payment
should be treated as an ?effective rebate? of U.K. taxes paid by Sovereign and
thus a ?tax effect? that should not be taken into account in determining
Sovereign?s pretax revenues from the trust transaction and consequently the
transaction?s prospect of profit?).
233. Id. at 241?44.
234. See id. at 241?42 (?[The loan] furnished the bank with capital to invest
in its business that had to be paid back.?).
235. See id. at 242 (following the same reasoning as the IES and Compaq
courts, but noting that the tax payments, unlike the STARS transaction at issue
here, were the result of arbitrage transactions).
contribution of assets to the trust did not have any economic
effects on the income, but instead was purely a jurisdictional
issue.237 Specifically, the court rejected the government?s claim
that ?the whole point of the purported tax avoidance scheme was
to generate an undeserved foreign tax credit and thus to avoid
paying a certain amount in taxes to Uncle Sam by paying an
equal amount to John Bull.?238
The court?s final point on the objective prong of the economic
substance doctrine originated from the Fifth Circuit?s reasoning
in Compaq.239 The court ruled that it would be stacking the deck
against the taxpayer to agree with ?the government?s bootstrap
position . . . that the tax payment should be included and the tax
credit excluded because if that is done, the transaction appears to
lack economic substance.?240
The First Circuit did not share the district court?s view on
Santander?s STARS transaction.241 Focusing solely on the issue of
the economic substance of the trust transaction, the First Circuit
?agree[d] with the reasoning of the Federal Circuit opinion in
Salem in rejecting the claims that the Trust transaction had
economic substance . . . substantially rely[ing] on its analysis.?242
The court noted that it was not necessary to address the nature of
the Bx payments, as the trust transaction had no reasonable
prospect for profit without taking into account the expected
foreign tax credits.243 Specifically ?[t]he Trust transaction is
profitless because the ?profit? to Sovereign from the Bx payment
comes at the expense of exposure to double the Bx payment?s
237. See id. at 243 (?What was changed was that Sovereign was paying
taxes on the income from the contributed assets to the U.K. rather than to the
239. See id. (referring to the view that if courts view foreign taxes paid as
expenses for the purposes of calculating pre-tax profits, they should also
?consider the effect of the offsetting of U.S. foreign tax credit[s]?).
241. See Santander Holdings USA, Inc. v. United States, 844 F.3d 15, 23?26
(1st Cir. 2016)
(reversing the district court?s decision and following the
reasoning of Salem and BNY).
242. Id. at 19.
243. See id. at 23 (agreeing with the Federal Circuit that the STARS trust
transactions were ?shaped solely by tax-avoidance features? (quoting Salem
Financial, Inc. v. United States, 786 F.3d 932, 942
(Fed. Cir. 2015)
value in U.K. taxes.?244 Finally, the First Circuit addressed the
district court?s ?stack the deck? argument, stating that the
economic reality of a transaction does not depend on whether ?the
transactions produced a net gain to the taxpayer after taking
both the foreign taxes and the foreign tax credit into account.?245
The court reasoned that taxpayers are only willing to enter into
tax shelter transaction at all because they produce a benefit
which taxpayers derive from the corresponding tax effects.246
The two preceding cases provide a perfect illustration for the
need of a definitive resolution of the question of how foreign
income taxes should be treated for the purpose of pre-tax profits.
The district court?s approach to the STARS transactions, and
similarly the objective prong of the economic substance test, is
fundamentally different to the alternative approach the First
Circuit advances.247 The district court?s ruling that the trust
transaction had economic substance because the underlying
assets themselves were substantive is fundamentally flawed, as it
disregards the altered use of the assets.248 However, narrowing
its focus to this limited aspect of the trust transaction, the court
disregarded the other parts of the trust that solely created tax
This conceptual dichotomy illustrates the need for uniform
application and clarification of the objective prong of the economic
substance doctrine. This is especially true considering the recent
district court cases under the jurisdiction of the Eighth Circuit.
244. Id. at 24.
245. Id. at 26 (quoting Salem Financial, Inc. v. United States, 786 F.3d 932,
(Fed. Cir. 2015)
246. See id. (?[B]ecause all tax shelter transactions produce a gain for the
taxpayer after the tax effects are taken into account?that is why taxpayers are
willing to enter into them and to pay substantial fees to the promoters.? (quoting
Salem Financial, Inc. v. United States, 786 F.3d 932, 948
(Fed. Cir. 2015)
247. Compare supra notes 231?240 and accompanying text, with supra notes
242?244 and accompanying text.
248. See Santander Holdings USA, Inc. v. United States, 144 F. Supp. 3d
239, 241?42 (D. Mass. 2015) (basing its argument on the fact that because the
assets were part of substantive transactions before the contribution to the trust,
they are therefore inevitably substantive under the trust as well).
B. Federal District Court of Minnesota:
Wells Fargo & Co. v. United States
One of the most recent district court decision stems from the
District Court of Minnesota in Wells Fargo & Co. v. United
States,249 under the jurisdiction of the Eighth Circuit. In Wells
Fargo, the district court ruled on a motion for summary
judgment, concluding that the STARS transaction at issue likely
lacked economic substance.250
Like the transactions in Salem, BNY, and Santander, this
case concerned the tax treatment of STARS transactions.251 While
the transactions in this case occurred between Wells Fargo and
Barclays, the mechanics of the STARS transactions are virtually
identical to the other STARS cases previously discussed.252
To review the STARS transaction, the district court, in
substance, applied the economic substance doctrine, beginning
with the objective inquiry.253 As a preliminary matter, the court
noted that when applying the economic substance doctrine ?the
transactions must be viewed as a whole?254 and that Wells Fargo
had the burden of proof to show that the transaction was ?not a
Beginning with the objective prong of the economic substance
doctrine, the court examined whether there was a reasonable
249. 143 F. Supp. 3d 827 (D. Minn. 2015).
250. See id. at 842?46 (relying primarily on the reasoning of the Federal and
Second Circuits, agreeing that foreign income taxes should be treated as
expenses for purposes of calculating pre-tax profits under the objective prong of
the economic substance doctrine).
251. Id. at 830.
252. See id. at 830?34 (using the same example as the Federal Circuit in
Salem to describe the elements of STARS); supra notes 154?174, 197?206 and
accompanying text (referring to the STARS transactions at issue in the
253. See Wells Fargo, 143 F. Supp. 3d at 834?46 (referring to the doctrine
formally as the ?sham-transaction doctrine,? but relying chiefly on the courts in
Salem and BNY, which applied the economic substance doctrine).
254. Id. at 834 (quoting IES Indus., Inc. v. United States, 253 F.3d 350, 356
(8th Cir. 2001)).
255. See id. (stating that claiming a tax deduction brings with it the burden
of proving that the transaction has economic substance (citing Coltec Indus.,
Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006))).
possibility of profit, focusing on the Bx payment first.256 Wells
Fargo argued that the Bx payment should be considered pretax
income, because it was paid from one private party to another as
compensation for services rendered.257 Additionally, Wells Fargo
argued that ?Barclays? obligation to make the Bx payment was
not contingent on Barclays? realization of tax benefits from the
STARS transaction,? and thus did not constitute a tax benefit or
partial rebate.258 While the court acknowledged some merit to the
argument, it was ultimately not persuaded.259 Relying on the
Federal Circuit?s reasoning in Salem, the court stated that ?[t]he
Bx payment . . . does not represent profit from any business
activity; it is simply the means by which Barclays and BB&T
shared the tax benefits of the Trust transaction.?260 In other
words, ?the Bx payment was not pretax revenue to Wells Fargo,
but instead Wells Fargo?s ?cut? of the tax benefits generated by
the STARS transaction.?261
One of Wells Fargo?s additional arguments is that the STARS
transactions, as a whole, had economic substance, because the
loan portion of the STARS transactions generated
tax-independent profits.262 While the district court agreed with
Wells Fargo that the loan itself likely resulted in pre-tax revenue,
it only did so ?when viewed in isolation.?263 Rather, the court
declined to rule ?as a matter of law that, because the loan had
256. See id. (?The characterization of the Bx payment is important to the
resolution of this [issue].? (quoting Salem Financial, Inc. v. United States, 786
F.3d 932, 940
(Fed. Cir. 2015)
257. See id. at 835 (?In Wells Fargo?s view, the Bx payment that it received
from Barclays is no different (for tax purposes) than, say, the payments that
Barclays? attorneys or accountants received for their work on the STARS
259. See id. at 835?36 (noting that, even though the Bx payment was
consideration in exchange for Wells Fargo subjecting its assets to U.K. taxation,
it ?lacked any economic substance whatsoever?).
260. Id. at 836.
261. Id. at 837.
262. Id. at 842 (?Wells Fargo argues, it had a reasonable expectation of
pretax profit because Wells Fargo?s anticipated (and actual) return on capital in
the ordinary course of its banking operations during the five-year period of the
loan exceeded 5.8 percent.?).
263. Id. at 843.
economic substance, the loan imbued the entire
transaction with economic substance.?264
Ultimately, the court concluded that Wells Fargo?s motions
for partial summary judgment should not be granted.265
Finally, it is important to note that the Federal and Second
Circuits squarely addressed the issue of whether foreign taxes
should be treated as expenses for calculating pre-tax profits. One
explanation may be that while the District Court of Minnesota
falls under the Eighth Circuit?s jurisdiction, the court followed
the Federal and Second Circuits? reasoning, putting it at odds
with the Eighth Circuit on the issue. At the moment of writing
this Note, the case has not completed trial. Thus, the issue might
still become an element of the final judgment. Regardless, the
case shows that the issue is far from settled.
V. Recommended Approach to the Objective Test of the Economic
From a financial standpoint, much is on the line for both
taxpayers and the government.266 The longer the circuit split
exists, the longer the uncertainty exists for both parties. Thus, a
resolution is essential, and in order to achieve the correct result,
the split should be resolved in favor of the Federal and Second
265. See id. at 853 (?[T]he Court has disagreed with the special master and
has held that the characterization of the Bx payment must await trial.?). The
court came to the same conclusion regarding the subjective?business purpose?
prong of the economic substance doctrine, denying Wells Fargo?s motion for
partial summary judgment that it had a non-tax business purpose. See id. at
845 (?[E]ven if the trust is considered to be part of the same transaction as the
loan, and even if the jury finds that the integrated STARS transaction had
economic substance, the jury might find that the integrated STARS transaction
lacked a business purpose.?).
266. See Bank of N.Y. Mellon Corp. v. United States, 801 F.3d 104, 104
(concerning a combined tax deficiency of $521.1 million for AIG and
BNY); Salem Fin., Inc. v. United States, 786 F.3d 932, 936
(Fed. Cir. 2015)
(disallowing $498.1 million in foreign tax credits); Compaq Comput. Corp. v.
Comm?r, 277 F.3d 778, 780 (5th Cir. 2001) (denying Compaq foreign tax credits
in the amount of $3.4 million); IES Indus., Inc. v. United States, 253 F.3d 350
(8th Cir. 2001) (?[IES c]laimed a foreign tax credit on the ADR dividends for the
amount of foreign tax withheld and paid to foreign governments, over $13.5
Circuits? approach. In other words, foreign taxes should be
treated as expenses for the purposes of determining whether the
taxpayer had a reasonable possibility of profit under the objective
prong of the economic substance doctrine.
A. The Federal and Second Circuits? Approach Is Preferable
The U.S. foreign tax credit regime aims ?to mitigate the evil
of double taxation.?267 As foreign investment ?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.?268 The regime
served to alleviate the burden of doing business in foreign
countries, and ?was intended to facilitate business abroad and
foreign trade.?269 However, it was not intended to provide the sole
basis for profit to taxpayers.270 Thus, when determining a
reasonable expectation for profit, the only sensible approach is to
exclude foreign tax credits from that determination, as they are
tax benefits and do not have an economic character.
Under this approach, the next logical step is to treat foreign
income taxes paid as expenses, rather than include them as
267. Burnet v. Chi. Portrait Co., 285 U.S. 1, 7 (1932). For more information
on foreign tax credits, see generally Bradley J. Tate, Foreign Tax Credit Basics,
AM. BAR ASSOC., http://www.americanbar.org/groups/young_lawyers/
visited Feb. 27, 2017) (on file with Washington and Lee Law Review); ZM
Ishmurzina, What Is Foreign Tax Credit? Ultimate Guide for US Taxpayers and
Expats, ARTIO PARTNERS,
https://www.artiopartners.com/blog/foreign-tax-creditguide-expats-abroad/ (last visited Feb. 27, 2017) (on file with the Washington
and Lee Law Review); Foreign Tax Credit, INTERNAL REVENUE SERV.,
https://www.irs.gov/individuals/ international-taxpayers/foreign-tax-credit (last
updated Dec. 16, 2016) (last visited Feb. 27, 2017) (on file with the Washington
and Lee Law Review); Foreign Tax Credit, INVESTOPEDIA,
http://www.investopedia.com/terms/f/foreign-tax-credit.asp (last visited Feb. 27,
2017) (on file with Washington and Lee Law Review).
Bank of N.Y. Mellon Corp., 801 F.3d at 107.
269. See id. (?We would discourage men from going out after commerce and
business in different countries . . . if we maintained this double taxation.? (citing
56 Cong. Rec. App. 677 (1918) (statement of Rep. Kitchin))).
270. See Wells Fargo & Co. v. United States, 143 F. Supp. 3d 827, 836 (D.
Minn. 2015) (emphasizing that tax credits are predicated by actual business,
and require more than ?exploiting differences among foreign tax codes? (quoting
Bank of N.Y. Mellon Corp., 801 F.3d at 113)).
profits. Foreign taxes are the very thing that give rise to foreign
tax credits, and it is illogical to divorce them from tax credits for
the purposes of calculating pre-tax profits.271 If the objective
prong of the economic substance doctrine is to provide a
meaningful analysis into the business reality of a transaction,
courts should disregard all tax considerations, including foreign
Not treating foreign taxes as expenses renders the objective
prong of the economic substance test toothless, as it would
include the very item which gives rise to a tax benefit. The
purpose of the economic substance analysis is ?to provide courts a
?second look? to ensure that particular uses of tax benefits comply
with Congress?s purpose in creating that benefit.?273
Including foreign taxes in the calculation of pre-tax profits
would mean that the taxpayer would always obtain the
corresponding tax benefit, provided the taxpayer contributed
enough assets to generate a substantial liability. For example,
the U.S. Court of Appeals for the Federal Circuit in Salem
disallowed $498.1 million in foreign tax credits.274 Thus, because
foreign tax credits are a dollar-for-dollar reimbursement of
foreign taxes paid, it can be inferred that the taxpayer in Salem
paid $498.1 million in foreign taxes.275 If the court had included
these foreign taxes paid in its determination of whether the
taxpayer had a reasonable expectation of profits, the taxpayer
would inevitably fulfill this requirement, as this amount is?by
any standard?substantial. This would defeat the purpose of the
271. See supra notes 214?215 and accompanying text (concluding that it is
appropriate to consider the effect of foreign taxes, but not the corresponding
credit in assessing pre-tax profit).
272. See Altria Grp., Inc. v. United States, 658 F.3d 276, 284 (2d Cir. 2011)
(noting that ?even if a transaction?s form matches the dictionary definitions of
each term used in the statutory definition of the tax provision, it does not follow
that Congress meant to cover such a transaction and allow it a tax benefit?).
273. Bank of N.Y. Mellon Corp., 801 F.3d at 113.
274. Supra note 266 and accompanying text.
275. See Ronald A. Worley, The Indirect Foreign Tax Credit: A Policy
Analysis of Section 902, 13 INT?L TAX & BUS. LAW. 176, 178 (1996) (?A tax credit
is a dollar for dollar reduction to taxes owed and, therefore, the foreign tax
credit generally has the effect of treating foreign taxes (on foreign source
income) as a ?down payment? on the taxpayers? U.S. tax liability.?).
objective prong of the economic substance doctrine, as it
incentivizes sham transactions such as STARS.276
The Fifth Circuit in Compaq concluded that ?[t]o count
[foreign taxes paid] only when they subtract from cash flow is to
stack the deck against finding the transaction profitable.?277 This
logic is not persuasive. The objective prong of the economic
substance doctrine is not intended to be an easy way for the
taxpayer to circumvent this necessarily rigorous inquiry.278
Disregarding foreign taxes paid does not ?stack the deck? against
the taxpayer, it provides an effective deterrent against taxpayer
abuses of the tax code.
Excluding foreign taxes in the determination of profits also
provides the best approach going forward.279 When it comes to
transactions such as STARS, ?[t]he endless ingenuity of
taxpayers in attempting to avoid taxes means that there will be a
first time for everything.?280 In other words, STARS transactions
will not be method taxpayers use to gain an illegitimate
advantage of tax benefits. This becomes particularly evident
when comparing the fairly simple ?dividend stripping?
transactions at issue in IES and Compaq on the one hand, and
the exceedingly complex STARS transactions in Salem, BNY,
Santander, and Wells Fargo.281 However, excluding foreign taxes
from the determination of profits will act as a disincentive for
276. See Bank of N.Y. Mellon Corp. v. United States, 801 F.3d 104, 117
(?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.? (citations
277. Compaq Comput. Corp. v. Comm?r, 277 F.3d 778, 785 (5th Cir. 2001).
278. See Bank of N.Y. Mellon Corp., 801 F.3d at 118 (?The purpose of
calculating pre-tax profit in this context is not to perform mere financial
accounting, subtracting costs from revenue on a spreadsheet: It is to discern, as
a matter of law, whether a transaction meaningfully alters a taxpayer?s
economic position other than with respect to tax consequences.?).
279. See id. (noting the economic substance doctrine ?was born out of
necessity, as ?[e]ven the smartest drafters of legislation and regulation cannot be
expected to anticipate every [tax avoidance] device.?? (quoting ASA Investerings
P?ship v. Comm?r, 201 F.3d 505, 513 (D.C. Cir. 2000))).
280. Wells Fargo & Co. v. United States, 143 F. Supp. 3d 827, 838 (D. Minn.
281. Supra notes 121?123, 152?171 and accompanying text.
taxpayers to engage in sham transactions, as taxpayers will be on
notice that the IRS will only take their actual economic profits
into account when determining the reasonable expectation for
B. The Solution for Resolving the Split
The final question left to be answered is how the above
suggestion?to treat foreign taxes paid as expenses for the
purposes of determining the reasonable expectation of profits
under the objective prong of the economic substance doctrine?
should be implemented in practice. There are three ways in
which this can occur. First, ? 7701(o)(2)(B) of the Internal
Revenue Code could be amended to require foreign taxes be
treated as expenses, eliminating the need for the Secretary of the
Treasury to promulgate regulations. Second, the Secretary of the
Treasury could promulgate regulations, as ? 7701(o)(2)(B)
currently allows. Third, the Supreme Court of the United States
could clarify the doctrine it initially created, providing flexibility
for lower courts in applying the doctrine.
Currently, Congress mandates that ?fees and other
transaction expenses? are treated as expenses, while foreign
taxes require the Secretary of the Treasury to promulgate
regulations for foreign taxes to count as expenses in appropriate
circumstances.282 The most comprehensive solution would be to
eliminate this distinction.
Congress could achieve this by merging foreign taxes into the
first sentence of ? 7701(o)(2)(B) and eliminating the second
sentence.283 Under this proposal, the new?single sentence?
? 7701(o)(2)(B) would read: ?Fees, foreign taxes, and other
transaction expenses shall be taken into account as expenses in
determining pre-tax profit under subparagraph (A).? This would
provide the most comprehensive solution and ensure uniform
application throughout the courts.
An alternative approach to amending ? 7701(o)(A)(B), is for
the Secretary of the Treasury to?in fact?promulgate
282. Supra notes 92?99 and accompanying text.
283. For the current two sentence structure of ? 7701(o)(2)(B), see supra
note 93 and accompanying text.
regulations. As of writing this Note, the Secretary has not
promulgated any such regulations.284
While the Secretary has issued a regulation disallowing
foreign tax credits for STARS transactions, the regulation does
not address the specific issue of whether foreign taxes should be
treated as expenses for the calculation of pre-tax profits.285
Additionally, ?the regulation does not purport to resolve the
circuit splits presented here, which concern issues that affect
transactions of any form, not just STARS.?286 Thus, the Secretary
would need to issue regulations which do not merely apply to a
specific transaction, but rather to certain types of transactions
which contain common elements. While this approach would
provide the flexibility for applying the objective prong of the
economic substance doctrine, as it would be able to apply to a
wide range of transactions, it would merely be a reactionary
method of dealing with the ever developing area of sham
The third option is for the Supreme Court to grant certiorari,
and resolve the circuit split. By means of a narrow holding, the
Supreme Court should rule that foreign taxes are treated as
expenses when determining the reasonable expectation of a
This approach would immediately resolve the circuit split
and would provide uniformity in application between the courts.
This option would also constitute an acceptable option going
forward, deterring taxpayers from entering into sham
transactions like STARS.
Of these three options, the best option is to amend
? 7701(o)(A)(B). This option constitutes the most comprehensive
solution, and would likely pre-empt any future variations
transactions such as STARS. Additionally, it would create
uniformity when calculating pre-tax profits for purposes of the
objective prong of the economic substance doctrine.
284. Supra note 103 and accompanying text.
285. See Petition for Writ of Certiorari, supra note 103, at 33 n.10 (?That
regulation applies only prospectively; it does not apply to this case or any other
pending STARS case.?).
The economic substance doctrine is in need of clarification.
As one of the most long-standing tax doctrines, as well as the
most prominent one today, a uniform application, particularly
regarding its objective prong, is crucial. The circuit split between
the Fifth and Eighth Circuits on the one hand, and the Federal,
Second Circuit, and most recently the First Circuit, on the other,
has led to considerable confusion and uncertainty for both
taxpayers and tax authorities. Because of this confusion,
hundreds of millions of dollars? worth of foreign tax credits are at
While the legislative clarification of the economic substance
doctrine provided some guidance on how to apply the doctrine, it
did not provide any meaningful guidance regarding foreign
income taxes. Thus, the stark dichotomy in treatment of foreign
income taxes for the purposes of calculating pre-tax profits under
the objective prong of the economic substance doctrine persists.
To eradicate this confusion, and to achieve the correct
treatment of foreign income taxes, the Federal and Second
Circuits? approach is preferable. To argue that treating foreign
income taxes as expenses, and excluding foreign tax credits from
the analysis of pre-tax profits is to ?stack the deck? is illogical and
leads to unintended results. It is impossible to divorce foreign
income taxes from foreign income tax credits, as the former gives
rise to the latter. Thus, they are both tax effects, which should
have no bearing on the determination of actual pre-tax profit.
Excluding foreign income taxes from the calculation of
pretax profits also provides the most consistent interpretation for
future tax shelter transactions. The evolution from the
?exdividend? transactions at issue in IES and Compaq to the highly
complicated STARS transactions in Salem, BNY, and Santander
make it reasonable to assume that in the future new, ingenious
tax shelters will arise, seeking to take advantage of the tax code.
However, by treating foreign income taxes as expenses for the
purposes of calculating pre-tax profits, the courts will be able to
quickly assess the true colors of a transaction.
As long as this circuit split exists, taxpayers and authorities
will likely be engaged in lengthy legal battles of tax shelter cases.
Treating foreign income taxes as expenses for pre-tax profit will
provide an effective deterrent for taxpayers to engage in such tax
arbitrage transactions in the first place.
Finally, the appropriate solution for resolving the circuit split
is to amend ? 7701(o)(A)(B). This would provide uniformity in
application of the objective prong of the economic substance
doctrine, and will significantly dampen the endless ingenuity of
taxpayers in creating sham transactions. Amending
? 7701(o)(A)(B) is the most appropriate solution going forward. In
the context of these complex cross-border transactions, the
economic substance doctrine is the gatekeeper to the legitimate
allowance of foreign tax credits. Specifically, without an effective,
and uniformly applied, objective prong and treatment of foreign
taxes as expenses, courts are left with an ineffective deterrent to
tax shelter shams. With hundreds of millions of dollars? worth of
foreign tax credits on the line, it is crucial for courts to be able to
distinguish between legitimate and illegitimate tax credits.
II. The Economic Substance Doctrine................................ 1174 A. History and Modern Use of the Economic Substance Doctrine.................................................. 1174 B. Clarification of the Economic Substance Doctrine .. 1183
III. The Circuit Split: Should Foreign Taxes Be Included in the Calculation of Pre-Tax Profits?. .......................... 1186 A. The Eighth Circuit: IES Industries, Inc . v. United States............................................................ 1187 B. The Fifth Circuit: Compaq Computer Corporation v. Commissioner.................................. 1190 C. The Federal Circuit: Salem Financial , Inc. v. United States ................... 1192 D. Second Circuit : Bank of New York Mellon Corporation v. Commissioner .................................. 1197
IV. Litigation in Other Jurisdictions .................................. 1201 A. A Case Study: The Recent First Circuit Decision: Santander Holdings USA, Inc . v. United States....................................... 1201 B. Federal District Court of Minnesota: Wells Fargo & Co. v. United States ............................................. 1205
V. Recommended Approach to the Objective Test of the Economic Substance Doctrine ............................. 1207 A. The Federal and Second Circuits' Approach Is Preferable ................................................................. 1208 B. The Solution for Resolving the Split....................... 1211 1. See Stobie Creek Invs . LLC v. United States , 608 F.3d 1366 , 1375 (Fed.
Cir . 2010 ) (arguing that courts ?[seek] to distinguish between structuring a real
creating a transaction to generate a tax benefit, which is illegitimate?). 2 . Business-Purpose Doctrine , BLACK'S LAW DICTIONARY (10th ed. 2014 ). 3. See Richard M. Lipton, ?Codification? of the Economic Substance
Doctrine-Much Ado About Nothing, SS017 ALI-ABA 1035 , 1035 ( 2010 )
judicial doctrines?) . 4. Id. (citing Gregory v . Helvering , 293 U.S. 465 , 468 - 70 ( 1935 )). 5 . See generally Salem Fin., Inc. v. United States , 786 F.3d 932 ( Fed . Cir.
2015 ). 6. See Bank of N.Y. Mellon Corp. v. United States , 801 F.3d 104 , 117 - 18
(2d Cir . 2015 ), cert. denied, 136 S. Ct . 1377 ( 2016 ) (expressly declining to follow
the Fifth and Eighth Circuits' prior reasoning) . 13. Infra Part IV. 14 . Infra Part V. 15 . Infra Part VI. 16 . See William J. Kolarik II & Steven N.J. Wlodychak , The Economic
Substance Doctrine in Federal and State Legislation, 67 TAX LAW . 715 , 721
( 2014 ) (requiring a taxpayer to determine, as a preliminary matter, whether an
?activity falls within or without the statute's text? ). 17 . Id . 18 . See id. (focusing instead on the legislative intent and ?the statute's
underlying justification?) . 19 . See id. at 723 (stating that the economic substance doctrine developed
simultaneously with other tax avoidance doctrines) . 20. See United Parcel Serv. of Am ., Inc. v. Comm'r , 254 F.3d 1014 , 1018 22 . No?l B. Cunningham & James R. Repetti , Textualism and Tax Shelters,
24 VA. TAX REV . 1 , 21 ( 2004 ) (citations omitted) . 23 . See Timothy H. Gillis & Ann L. Holley, States Apply the Federal Sham
Transaction Doctrine to Intangibles Holding Companies, 98 J. TAX'N 173 , 176
( 2003 ) (noting that this is often used interchangeably with the term ?economic
substance? (quoting Rice's Toyota World , Inc. v. Comm'r , 752 F.2d 89 , 96 (4th
Cir . 1985 ))). 69 . Id. at 569 . 70. See id. at 570 (claiming ?that Lyon was not the true owner of the
building and therefore was not entitled to the claimed deductions? ). 71 . Id. at 570 . 72. See id. at 572 ( ?In sum, the benefits , risks, and burdens which [Lyon]
to establish a claim to the status of owner for tax purposes . ?) . 73 . See id. at 583 (finding ?a genuine multiple-party transaction with
economic substance?) . 74 . Kolarik II & Wlodychak, supra note 16, at 749 . 75. Frank Lyon Co. v. United States , 435 U.S. 561 , 583 - 84 ( 1978 )
(emphasis added); see also Sancilio, supra note 58, at 144 (describing the
and the Application of the Strict Liability Penalty , 64 CLEV. ST. L. REV. 109 , 115
( 2015 ) (marking this phrasing as the moment when ?[t]he business purpose
has become known as the 'economic substance doctrine'? ). 76 . Frank Lyon, 435 U.S. at 561 . 103. Petition for Writ of Certiorari at 33, Bank of N.Y. Mellon Corp. v.
Comm'r , 2015 WL 6690397 ( 2015 ) (No. 15 - 572 ) [hereinafter Petition for Writ of
writing this Note . 104 . See id. (?Absent any prospective regulation on that issue, courts
continue to apply their own inconsistent rules . ?). 105. Supra note 10 and accompanying text. 106. Supra notes 5-8 and accompanying text. 107 . See Rice's Toyota World , Inc. v. Comm'r , 752 F.2d 89 , 117 (4th Cir.
1985 ) (discussing that economic substance must go beyond a mere tax gain ). 108. See Petition for Writ of Certiorari, supra note 103 , at 33 (listing various
credits) . 184. See id. at 944 ( basing its argument on the seminal Supreme Court case,
Old Colony Trust Co. v. Commissioner, 279 U.S. 716 , 721 , 729 ( 1929 )).