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Salem Financial, Inc. v. United States

United States Court of Appeals, Federal Circuit

May 14, 2015

SALEM FINANCIAL, INC., as Successor-in-Interest to Branch Investments LLC, Plaintiff-Appellant
UNITED STATES, Defendant-Appellee

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[Copyrighted Material Omitted]

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[Copyrighted Material Omitted]

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Appeal from the United States Court of Federal Claims in No. 1:10-cv-00192-TCW, Judge Thomas C. Wheeler.

RAJIV MADAN, Skadden, Arps, Slate, Meagher & Flom LLP, Washington, DC, argued for plaintiff-appellant. Also represented by CHRISTOPHER PAUL BOWERS, ROYCE TIDWELL, CHRISTOPHER PATRICK MURPHY, NATHAN P. WACKER; MATTHEW JAMES DOWD, SCOTT M. MCCALEB, Wiley Rein, LLP, Washington, DC.

JUDITH ANN HAGLEY, Tax Division, United States Department of Justice, Washington, DC, argued for defendant-appellee. Also represented by TAMARA W. ASHFORD, GILBERT STEVEN ROTHENBERG, RICHARD FARBER.

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


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Bryson, Circuit Judge.

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



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

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

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

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

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

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that Barclays would obtain from the U.K. based on its participation in the transaction.

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

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


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

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

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

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

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

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

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

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

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

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

The U.K. government effectively collected $3.30 in tax for every $100 of Trust income, because the Trust paid $22 in U.K. taxes while the U.K. government gave back $18.70 in tax benefits to Barclays ($15.40 attributable to the trading loss deduction plus $3.30 attributable to the Bx payment deduction). Based on the structure of the transaction and the amount of the income-generating assets in the Trust, BB& T anticipated receiving approximately $44 million per year from the STARS Trust transaction in addition to the revenue generated by the assets themselves.

The capacity of the STARS Trust transaction to generate profits for Barclays and BB& T depended both on Barclays' obtaining the expected tax benefits from the U.K. and on BB& T's obtaining the expected foreign tax credits from the U.S. Because of the risks associated with obtaining those tax benefits, the parties incorporated features into the Trust agreement that were designed to minimize those

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risks. The agreement included a " makewhole" provision under which BB& T was obligated to reimburse Barclays if the credits generated by the Trust failed to match the parties' expectations. The parties also agreed to an indemnity provision, which would be triggered if the Trust paid no tax, either because it was not treated as a collective investment scheme under U.K. law or because it was not deemed a U.K. resident. BB& T's indemnity payment to Barclays would be approximately one-half of the U.K. tax that the Trust would have paid. Finally, both parties were entitled to terminate the STARS transaction for any reason, subject to 30 days' notice.

On March 30, 2007, the IRS published proposed regulations entitled " Regulations on Transactions Designed to Artificially Generate Foreign Tax Credits," 72 Fed. Reg. 15081 (proposed Mar. 30, 2007). The comments accompanying the proposed regulations noted that " certain U.S. taxpayers are engaging in highly structured transactions with foreign counterparties in order to generate foreign tax credits," id. at 15081, and explained that the regulations were intended to prohibit the use of " highly engineered transactions where the U.S. taxpayer benefits by intentionally subjecting itself to foreign tax," id. at 15084. Under the regulations, " an amount paid to a foreign country in connection with such an arrangement is not an amount of tax paid," and as a consequence, " a taxpayer would not be eligible to claim a foreign tax credit for such a payment." Id. The notice of the proposed regulation stated that the IRS would analyze STARS transactions entered into before the effective date of the final regulation under anti-abuse doctrines, including the economic substance doctrine. 72 Fed. Reg. 15084 (Mar. 7, 2007). Six days after the issuance of the proposed regulations, BB& T terminated the STARS transaction pursuant to its at-will termination right.


BB& T filed corporate income tax returns for the tax years when it was participating in the STARS transaction. In its returns, BB& T claimed foreign tax credits for the Trust's U.K. tax payments and interest deductions for interest it had paid on the Loan. The IRS denied both claims and imposed accuracy-related penalties on BB& T.

BB& T filed suit in the Court of Federal Claims, seeking a tax refund for the items listed above. Following a lengthy trial, the court denied BB& T's refund request in its entirety. Salem Fin., Inc. v. United States, 112 Fed.Cl. 543 (2013). Applying the " economic substance" doctrine, the court concluded that the STARS Trust was an economic sham lacking both objective economic reality and a bona fide non-tax business purpose. The court therefore held that the tax consequences of the STARS transactions had to be disregarded.

The court ruled that the Trust component, " where BB& T revenue momentarily is cycled through a U.K. trustee to create U.K. taxes and foreign tax credits, and then is returned to BB& T, quite clearly is an abusive tax avoidance scheme." 112 Fed.Cl. at 549. The court explained that the Trust " creates a series of instantaneous circular cash flows starting and ending with BB& T where no economic activity has occurred abroad to justify the assessment of a U.K. tax. While inarguably sophisticated and creative, the trust purely and simply is a sham transaction accomplishing nothing more than a redirection of cash flows that should have gone to the U.S. Treasury, but instead are shared among BB& T, Barclays, and the U.K. Treasury." Id.

The court also denied BB& T's claim for interest deductions on the Loan component

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of the STARS transaction, based on a finding that the STARS Loan, too, was an economic sham. The court reasoned that the Loan was not structured to make a profit, but instead was devised merely to provide BB& T with a purported business purpose for engaging in the STARS transaction. 112 Fed.Cl. at 587.

The court also examined the Trust and the Loan as part of a single integrated transaction under the economic substance doctrine. It concluded that, viewed as an integrated transaction, the components of the STARS transaction still lacked economic substance. 112 Fed.Cl. at 588-89.

Finally, the court upheld the accuracy-related penalties assessed by the IRS. The court found that it was unreasonable for BB& T to rely on tax opinions from KPMG and Sidley, as well as the additional advice from PwC. The court thus concluded that the tax opinions were ineffective to create a reasonable justification for BB& T's understatements of its tax liability and that the imposition of penalties was proper. 112 Fed.Cl. at 589-94. This appeal ensued.[2]


The characterization of a transaction for tax purposes is a question of law that is subject to de novo review, while the underlying facts are reviewable for clear error. Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978). For purposes of this appeal, BB& T " accepts the trial court's holding that the Trust Transaction and the Loan may be bifurcated." Appellant's Br. 18. That is, both sides treat the tax consequences of the Trust and Loan transactions separately, rather than considering them as a single integrated transaction. We accordingly take the same approach and start with the Trust.


The characterization of the Bx payment is important to the resolution of this case. The government argues that the Bx payment is in substance a rebate of the U.K. taxes that BB& T paid on behalf of the Trust. BB& T contends that under the Internal Revenue Code and the Treasury Regulations, the Bx payment must be treated as income to BB& T and not as a tax rebate.

Section 901(i) of the Code provides that payments made to a foreign country that result in a subsidy or rebate to the taxpayer from that country are not creditable taxes. See 26 U.S.C. § 901(i)(1)-(2). Under section 901(i),

Any income, war profits, or excess profits tax shall not be treated as a tax for purposes of this title to the extent -- (1) the amount of such tax is used (directly or indirectly) by the country imposing such tax to provide a subsidy by any means to the taxpayer, a related person (within the meaning of section 482), or any party to the transaction or to a related transaction, and ...

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