Santander Holdings USA, Inc. v. US

Filing

OPINION issued by Sandra L. Lynch, Appellate Judge; Bruce M. Selya, Appellate Judge and Allison Dale Burroughs,* U.S. District Judge. Published. *Of the District of Massachusetts, sitting by designation. [16-1282]

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Document: 00117094045

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Date Filed: 12/16/2016

Entry ID: 6055691

United States Court of Appeals
For the First Circuit
No. 16-1282
SANTANDER HOLDINGS USA, INC., and Subsidiaries,
f/k/a Sovereign Bancorp., Inc.,
Plaintiff, Appellee,
v.
UNITED STATES OF AMERICA,
Defendant, Appellant.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. George A. O'Toole, Jr., U.S. District Judge]

Before
Lynch and Selya, Circuit Judges,
and Burroughs, District Judge.

Judith A. Hagley, with whom Caroline D. Ciraolo, Acting
Assistant Attorney General, Tax Division, Diana L. Erbsen, Deputy
Assistant Attorney General, Tax Division, Gilbert S. Rothenberg,
Richard Farber, and Carmen M. Ortiz, United States Attorney, were
on brief, for appellant.
Jonathan S. Massey, with whom Leonard A. Gail, Paul J. Berks,
Massey & Gail LLP, Rajiv Madan, and Skadden, Arps, Slate, Meagher
& Flom LLP were on brief, for appellee.
Martin S. Kaufman on brief for Atlantic Legal Foundation,
amicus curiae.
Scott P. Martin, Gibson, Dunn & Crutcher LLP, Kate Comerford
Todd, Steven P. Lehotsky, Warren Postman, and U.S. Chamber


Of the District of Massachusetts, sitting by designation.

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Litigation Center on brief for Chamber of Commerce of the United
States of America, amicus curiae.
Derek T. Ho, Bradley E. Oppenheimer, William H. Milliken,
Kellogg, Huber, Hansen, Todd, Evans & Figel, P.L.L.C., and K.
Richard Foster on brief for Financial Services Roundtable, amicus
curiae.
December 16, 2016

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LYNCH, Circuit Judge.

Date Filed: 12/16/2016

Entry ID: 6055691

Under the Internal Revenue Code,

taxpayers receive, subject to various technical requirements,
credits against owed U.S. income tax for every dollar paid to a
foreign country for taxable international business transactions of
economic substance.

See 26 U.S.C. §§ 901–909.

Over the past

decade, some banks have engaged in complicated transactions the
very purpose of which is to generate a foreign tax credit in order
to take advantage of the U.S. deductions, and have done so at the
expense of the U.S. taxpayer.
This case concerns whether Sovereign Bancorp, Inc.,
later

acquired

by

Santander

Holdings

USA,

Inc.

(together,

"Sovereign"), a U.S. taxpayer, is entitled to a refund from the
Internal Revenue Service ("IRS") after the IRS began disallowing
its claim for foreign tax credits and imposing accuracy-related
penalties in 2008.

The credits at issue here were claimed for tax

years 2003 to 2005 for taxes arranged to be paid to the United
Kingdom

as

part

of

a

Structured

Trust

Advantaged

Repackaged

Securities ("STARS") transaction that Sovereign had engaged in.
This STARS transaction was initiated in 2003 and was scheduled to
last five years, but it ended early, in July 2007, when STARS and
similar transactions became the subject of heightened scrutiny
from the IRS.

See Determining the Amount of Taxes Paid for

Purposes of Section 901, 72 Fed. Reg. 15,081 (proposed Mar. 30,
2007).

Sovereign

and

Barclays

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Bank

("Barclays"),

which

is

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chartered in the United Kingdom, were the two parties to the
transaction at issue.
Sovereign brought suit to obtain a refund from the IRS
in the District of Massachusetts in 2009.

The amount of the refund

sought is approximately $234 million in taxes, penalties, and
interest.

Sovereign asserts that it is entitled to foreign tax

credits against its U.S. taxes for taxes it paid to the United
Kingdom as part of the STARS transaction at issue.

As the

government concedes, the STARS transaction complied on its face
with then-existing U.S. statutory and regulatory requirements.
But the government opposes the refund, arguing that the STARS
transaction here is an "abusive tax shelter" and so amounts to a
transaction that fails the common law economic substance test.
Congress and the IRS have long been concerned with
taxpayers

inappropriately

seeking

foreign

tax

credits.

IRS

regulations proposed in 2007 and finalized in 2011 prohibited STARS
transactions, but not retroactively.

See Determining the Amount

of Taxes Paid for Purposes of Section 901, 72 Fed. Reg. 15,081,
15,084 (proposed Mar. 30, 2007); Determining the Amount of Taxes
Paid for Purposes of the Foreign Tax Credit, 76 Fed. Reg. 42,036
(July 18, 2011) (codified at 26 C.F.R. pt. 1).
reflect

an

understanding

that

STARS

The regulations

transactions

and

similar

complex financial structures for which foreign tax credits are
sought both pose a danger to the federal fisc and do not serve the

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purposes intended by Congress in enacting the foreign tax credit
regime.

Those purposes include avoiding double taxation and

enabling the conduct of business affairs abroad by U.S. firms.
See H.R. Rep. No. 83-1337, at 4103 (1954) ("The [foreign tax
credit] provision was originally designed to produce uniformity of
tax burden among United States taxpayers, irrespective of whether
they were engaged in business in the United States or engaged in
business abroad.").

This case involves a STARS transaction that

took place before such transactions were forbidden by regulation,
and no one contends the 2011 regulation applies.

This decision

thus directly affects only that transaction.
During roughly the same period as the transaction at
issue here, from 2001 to 2007, other U.S. banks also entered into
STARS transactions with Barclays.

They similarly sought tax

credits, and the IRS similarly opposed them.

In Bank of New York

Mellon Corp. v. Commissioner (BNY), 801 F.3d 104, 107 (2d Cir.
2015), the Second Circuit affirmed a judgment disallowing the
credits

claimed

by

Bank

transaction with Barclays.1

of

New

York

Mellon

for

its

STARS

Using somewhat different reasoning,

1

We note that while we discuss the findings of the Second
Circuit in BNY, our opinion does not rely in any sense on the
earlier opinion of the tax court in that case. See Bank of N.Y.
Mellon Corp. v. Comm'r, 140 T.C. 15, as amended by 106 T.C.M. (CCH)
367 (T.C. 2013). Because we do not rely on that opinion, we need
not address Sovereign's argument that the judge in that case
suffered from a conflict of interest, a claim the government
vigorously disputes.

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the Federal Circuit in Salem Financial, Inc. v. United States, 786
F.3d 932, 951, 954–55 (Fed. Cir. 2015), also upheld a determination
disallowing credits claimed by Branch Banking & Trust Corporation
for

a

STARS

opinions

transaction

contain

with

extensive

Barclays.

factual

Both

circuit

court

of

STARS

descriptions

the

transactions, which also largely characterize the transaction at
here. 2

issue

A

third

case,

involving

a

Wells

Fargo

STARS

transaction, was tried in a federal district court in the Eighth
Circuit.

See Wells Fargo & Co. v. United States, 143 F. Supp. 3d

827, 842 (D. Minn. 2015). After trial, a jury found that the
transaction lacked economic substance.
The Massachusetts district court in this case awarded
summary judgment to Sovereign.

It first entered partial summary

judgment for Sovereign on the issue of whether a payment Sovereign
received from Barclays should be considered income to Sovereign in
calculating

the

STARS

Trust

transaction's

profit.

Santander

Holdings USA, Inc. & Subsidiaries v. United States (Santander I),
977 F. Supp. 2d 46, 48 (D. Mass 2013).

It then entered judgment

for Sovereign after finding as a matter of law that the Trust and

2

Although Sovereign argues on appeal that the transaction
in BNY is distinguishable, it conceded below that the transaction
was "very similar" to the one at issue here. And while Sovereign
contends that the bank in Salem adopted a different litigation
strategy than the one pursued by Sovereign, it does little to
demonstrate that the STARS transaction in Salem involved any
materially different facts.

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Loan transactions had economic substance, and so Sovereign was
entitled to interest-related deductions on expenses for the Loan
transaction and a refund on the disallowed foreign tax credits
claimed for the Trust transaction and the penalties imposed by the
IRS.

Santander Holdings USA, Inc. v. United States (Santander

II), 144 F. Supp. 3d 239, 248 (D. Mass. 2015).

The court also

denied the government's cross-motion for partial summary judgment
in its favor on a number of issues, including whether Sovereign's
U.K. taxes should be regarded as expenses in any calculation of
Sovereign's profit from the STARS transaction.
248.

Id. at 242-44,

The government appeals from the grant of summary judgment

to Sovereign and the denial of its cross-motion.
Through concessions made by both the government and
Sovereign, the appeal has been considerably simplified.

The

government no longer contends that it is entitled to a jury trial
on the tax refund claim; it seeks a jury trial only on the penalties
claim.

The government also does not contend any longer that the

district court improperly excluded evidence, or that there are any
material disputes of fact, or that summary judgment was entered
prematurely.

Rather, the government agrees that the controlling

issue is one of law and argues that its cross-motion for summary
judgment as to the Trust portion of the STARS transaction should

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Sovereign, for its part, agrees, for the

purposes of summary judgment, that the proper focus is on the Trust
transaction alone, and not on the Loan transaction.4
We hold that the district court committed reversible
error and that the government is entitled to summary judgment in
its

favor

as

transaction.

to

the

economic

substance

of

the

STARS

Trust

We largely agree with the reasoning of the Federal

Circuit opinion in Salem in rejecting the claims that the Trust
transaction had economic substance and substantially rely on its
analysis.
I.
We give a brief description of the transaction and then
of this Circuit's economic substance test.

3

The government also argued to the district court that
the foreign tax credits claimed by Sovereign should be denied on
the basis of two "substance over form" doctrines, the "step
transaction" and "conduit" doctrines, but the district court
rejected the argument. Santander II, 144 F. Supp. 3d at 244. As
the government focuses its appeal on the economic substance
doctrine, we do not consider the district court's rejection of the
government's substance-over-form argument.
4

The parties have agreed for purposes of this appeal that
the Trust transaction should be analyzed separately from the Loan
transaction. The bank in Salem similarly accepted the bifurcation
of the tax consequences of the Trust transaction and the Loan
transaction for purposes of that appeal. Salem, 786 F.3d at 940.
The government no longer contests the economic substance
of the Loan transaction, as long as the Loan transaction is
analyzed separately from the Trust transaction, and does not appeal
the district court's decision that Sovereign may claim certain
interest-expense deductions.

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A.

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The STARS Transaction
Sovereign

Barclays in 2003.

entered

into

the

STARS

transaction

with

U.S. banks were then aware of the tax risks of

being denied the full amount of U.S. foreign tax credits.
e.g., Salem, 786 F.3d at 937.

See,

Like other STARS transactions, the

one Sovereign entered into had, as the district court put it, a
"Rube Goldberg" complexity.

Santander I, 977 F. Supp. 2d at 48.

We explain it briefly and rely on BNY and Salem for further
details.
In 2003, Sovereign first created a Trust (the Trust half
of the transaction) into which it ultimately contributed about
$6.7 billion of its U.S.-located income-producing assets.

The

trustee of the Trust was, by its terms, a U.K. citizen, a fact
which subjected the Trust to U.K. taxes.
a rate of 22%.

The U.K. taxes were at

The Trust was also subject to U.S. federal income

tax at a rate of 35%, but it could claim a tax credit for the taxes
paid to the United Kingdom.

The Trust was structured, therefore,

to receive foreign tax credits for the amount paid in tax on the
Trust to the United Kingdom.

It is undisputed that Sovereign paid

all U.K. taxes for which it claimed U.S. tax credits.
Barclays acquired an interest in the Trust for $750
million in November 2003 at the Trust's initial creation and
acquired an additional $400 million interest almost a year later,
when

Sovereign

added

additional

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funds

to

the

Trust.

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Significantly, Barclays was required to sell its interest in the
Trust back to Sovereign for $1.15 billion at the end of the
transaction.
Sovereign treated this $1.15 billion contribution from
Barclays as a Loan (the Loan half of the STARS transaction) for
accounting

and

regulatory

purposes,

including

in

all

of

Sovereign's filings to the Securities and Exchange Commission and
the Office of Thrift Supervision.

The offsetting agreements that

converted Barclays's purchase of an interest in the Trust into the
Loan

effectively

resulted

in

Barclays

lending

million at a floating monthly rate of LIBOR5

Sovereign

$750

plus 50 basis points

and $400 million at LIBOR plus 25 basis points.6
The Trust engaged in a series of actions that generated
a U.K. tax benefit for Barclays.

The Trust distributed funds to

a Barclays Blocked Account, which Barclays could not access, but

5

LIBOR stands for "Intercontinental Exchange London
Interbank Offered Rate." Salem, 786 F.3d at 937 n.1. LIBOR "is
a benchmark rate that some of the world’s leading banks charge
each other for short-term loans." Id.
6

When it first marketed this transaction to potential
counterparties, Barclays did not include this Loan component. See
Salem, 786 F.3d at 936.
The government suggests that Barclays
added the Loan to "disguise the true nature of the [transaction]
and permit U.S. taxpayers to justify STARS as low-cost funding."
Sovereign asserts that "there is no evidence . . . that any nonloan transaction was ever offered to (or considered by) Sovereign,"
and that "[t]o the extent Barclays may have proposed a non-loan
transaction to other banks, the evidence shows they were
uninterested in it." Because we must analyze the Loan and Trust
transactions separately, this dispute is immaterial.

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which allowed Barclays to formally hold the funds in its name.
The Barclays Blocked Account then immediately returned the funds
to the Trust.

Barclays owed U.K. taxes on the distributions made

to the Barclays Blocked Account, but, importantly, Barclays was
entitled to a tax credit for the U.K. tax paid on this income by
the Trust, and Barclays also was permitted to deduct its recontributions to the Trust as a tax loss.

The combination of the

tax credit and deduction "creat[ed] a net tax deduction for
Barclays that it could use to offset tax on other income unrelated
to [the STARS transaction]."
In exchange, Barclays paid Sovereign a monthly sum,
referred to as the "Barclays" or "Bx" payment.

The amount of the

Bx payment was calculated to equal 50% of the U.K. tax Sovereign
paid on the Trust's income.

In a sense, the 50% was a return to

Sovereign of half of its tax payment, whether or not it was
technically

a

rebate.

The

Bx

payment

was

"netted

against

Sovereign's interest obligation" on the Loan.
The benefits for both parties can be illustrated by a
hypothetical also employed by the Second and Federal Circuits.
See BNY, 801 F.3d at 111; Salem, 786 F.3d at 938.
income in the Trust for a given month.

Assume $100 of

Through its ownership

interest in the Trust and the Trust's structure, Barclays would be
liable

for

a

30%

amounting to $30.

U.K.

corporate

tax

on

BNY, 801 F.3d at 111.

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the

Trust's

income,

Barclays would then

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claim a credit for the 22% U.K. tax paid on the Trust by Sovereign
amounting to $22, bringing Barclays's own tax liability down to
$8.

Id.

The Trust would set aside $22 to settle the U.K. tax

owed by Sovereign; the remaining $78 would be shuttled into and
out of the Barclays Blocked Account.

Id.

Sovereign would claim

a U.S. foreign tax credit for the $22 it paid in U.K. taxes.
Upon

redistributing

the

$78

to

the

Trust

from

Id.
the

Barclays Blocked Account, Barclays would claim a trading loss
deduction on the $78 which, at the corporate tax rate of 30%, would
amount to $23.40.

Id.

Barclays would make a Bx payment to

Sovereign calculated to be half of the 22% U.K. tax paid by
Sovereign, which would amount to $11.

Id.

Barclays then deducted

this payment at the 30% U.K. tax rate as well, resulting in a $3.30
deduction.

Id.

In the end, Barclays would save $7.70 in taxes

for each $100 of Trust income ($23.40 – $8 – $11 + $3.30), and
Sovereign would save $11 (the amount of the Bx payment calculated
against

Sovereign's

U.K.

tax

exposure).

Id.

Both

parties

ultimately reduced their tax exposure -- Barclays through the
various

deductions

generated

by

Sovereign through the Bx payment.

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the

Trust

transaction

and

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The Economic Substance Doctrine
The federal income tax is, and always has been, based on

statute.

The economic substance doctrine,7 like other common law

tax doctrines, can thus perhaps best be thought of as a tool of
statutory interpretation,8 as then-Judge Breyer characterized it
in his opinion for this court in Dewees v. Commissioner, 870 F.2d
21, 35–36 (1st Cir. 1989).
The common law economic substance doctrine traces back
to the Supreme Court's decision in Gregory v. Helvering, 293 U.S.
465 (1935). 9

The Court there looked beyond the fact that a

7

Sovereign argues that the foreign tax credit area is so
heavily populated with IRS regulation that there is no need for
any further regulation by the courts under the guise of the
economic substance doctrine.
On these facts, we reject the
proposition. In practical terms, it takes time for the government
to analyze a new problem, come up with a solution, and promulgate
regulations. "The endless ingenuity of taxpayers in attempting
to avoid taxes means that there will be a first time for
everything," Wells Fargo, 143 F. Supp. 3d at 838, and the economic
substance test guards against abuse of loopholes that Congress and
the IRS have not anticipated.
8

As one commentator says:

A related . . . claim is that the legislature assumes
that long-standing common law doctrines such as economic
substance will be used to interpret the statutes it
enacts.
Under this claim, the doctrines have been
implicitly adopted as part of the statute -- at least
where the statute does not indicate otherwise.
Joseph Bankman, The Economic Substance Doctrine, 74 S. Cal. L.
Rev. 5, 11 (2000).
9

In 2010, Congress enacted a statutory economic substance
test. See 26 U.S.C. § 7701(o). The statutory test was not made
retroactive. Our analysis, however, is not in conflict with that
test, as Congress specified that the 2010 codification would be
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corporate reorganization technically complied with the statutory
requirement and found that it lacked economic substance.
468–70.

Id. at

It found as such because the reorganization was:

an operation having no business or corporate purpose —a mere device which put on the form of a corporate
reorganization as a disguise for concealing its real
character, and the sole object and accomplishment of
which was the consummation of a preconceived plan, not
to reorganize a business or any part of a business, but
to transfer a parcel of corporate shares to the
petitioner.
Id. at 469.

The Court reached this conclusion from the fact that

"the transaction upon its face lies outside the plain intent of
the statute."

Id. at 470.

The Court clarified the doctrine further in Frank Lyon
Co. v. United States, 435 U.S. 561 (1978), where it reversed the
Eighth Circuit's decision that a sale-and-leaseback transaction
did not meet the economic substance test.

Id. at 584.

The Court

explained that "[i]n applying this doctrine of substance over form,
the Court has looked to the objective economic realities of a
transaction
employed."

rather

than

to

the

particular

form

the

parties

Id. at 573 (emphasis added).
The

First

Circuit

has

addressed

challenges

to

the

economic substance of transactions in a number of cases, although

applied as courts have previously and consistently applied the
economic substance doctrine.
Id. § 7701(o)(5)(C).
If the
codification reveals anything about congressional intent as to
pre-2010 STARS transactions, it supports our conclusion.

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the cases often have not invoked the "economic substance doctrine"
by that name.

See, e.g., Stone v. Comm'r, 360 F.2d 737 (1st Cir.

1966); Fabreeka Prods. Co. v. Comm'r, 294 F.2d 876 (1st Cir. 1961);
Granite Tr. Co. v. United States, 238 F.2d 670 (1st Cir. 1956).
This court has been particularly wary of inquiring into the
subjective motivations of taxpayers:

"[U]nless Congress makes it

abundantly clear, we do not think tax consequences should be
dependent upon the discovery of a purpose, or a state of mind,
whether it be elaborate or simple."

Fabreeka Prods. Co., 294 F.2d

at 878.
Dewees

is

our

most

economic substance doctrine.

recent

significant

case

on

the

There, this court upheld a tax court

decision that a "loss [the petitioners] incurred while engaged in
'straddle' trading on the London Metals Exchange was not an
'ordinary loss' deductible from their income."
at 22.

Dewees, 870 F.2d

The tax court held that the loss was not deductible because

the straddle trades were sham transactions and not "entered into
for profit" within the meaning of section 108 of the Internal
Revenue Code.

Id.

This court upheld the tax court's decision for four
principal reasons.

We emphasized that the case was one of some

1,100 consolidated by the tax court, from the general pattern of
which the tax court could infer that the transactions were designed
to avoid taxes; that the promotional material for the transactions

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focused exclusively on their tax effects; that although margin
accounts were opened for the transactions, none of the investors
in any of the transactions ever received a margin call; and that
no investor ever made a net profit or "was ever asked to pay a
loss, beyond the initial margin deposit" for the transactions.
Id. at 31.

10

We rejected the petitioner's argument that we must

analyze the taxpayer's subjective motivation under the relevant
statutory framework.

Id. at 34.

Among other reasons, the court

noted that the tax court had concluded that the transactions were
"shams in substance," and that "[c]ase law makes clear that a
taxpayer cannot deduct a 'sham transaction' loss, irrespective of
his subjective profit motive."

Id. at 35.

Dewees instructs that the economic substance doctrine is
centered

on

objectively

discerning
"lies

statutory regime]."
It

further

whether

outside

the

the

plain

challenged
intent

of

transaction

the

[relevant

Id. at 29 (quoting Gregory, 293 U.S. at 470).

instructs

that

a

transaction

10

fails

the

economic

To the extent that similar evidence is in the record for
this case, it supports our conclusion.
As in Dewees, we have
examined the pattern that has emerged from comparable STARS
transactions.
We
have
used
Sovereign's
and
Barclays's
communications to each other about the transaction and, in
particular, their emphasis on the connection of the Bx payment to
Sovereign's U.K. taxes and the Trust transaction's "tax risk," to
conclude that the Trust transaction had no objective purpose
outside its tax effect. And we too have noted that the transaction
at issue here was structured such that it exposed neither party to
realistic non-tax risk.

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substance test if, "though [it] actually occurred and technically
complied with the tax code, [it] w[as] mere[ly a] device[] to avoid
tax liability."

Id. at 30; see also Schussel v. Werfel, 758 F.3d

82, 97 (1st Cir. 2014) (noting that courts may "disregard the form
of transactions that have no business purpose or economic substance
beyond tax evasion").

In other words, when a transaction "is one

designed to produce tax gains . . . [not] real gains," Dewees, 870
F.2d at 31 -- such as when the challenged transaction has no
prospect for pre-tax profit -- then it is an act of tax evasion
that, even if technically compliant, lies outside of the intent of
the Tax Code and so lacks economic substance.
II.
"We review orders granting or denying summary judgment
de novo."

Fithian v. Reed, 204 F.3d 306, 308 (1st Cir. 2000).

"The general characterization of a transaction for tax purposes is
a question of law subject to review."

Frank Lyon, 435 U.S. at 581

n.16.
In its first partial summary judgment decision, the
district court rejected the government's argument that the Bx
payment was in effect a tax rebate.
at 50.

Santander I, 977 F. Supp. 2d

The district court concluded instead that the Bx payment

as a matter of law was income to Sovereign.

Id. at 52.

The

Federal Circuit reached the same conclusion as the district court
in our case and held that the Bx payment must be counted as income

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under the logic of Old Colony Trust Co. v. Commissioner, 279 U.S.
716 (1929); IES Industries, Inc. v. United States, 253 F.3d 350
(8th Cir. 2001); and Compaq Computer Corp. & Subsidiaries v.
Commissioner, 277 F.3d 778 (5th Cir. 2001).
944–46.

Salem, 786 F.3d at

By contrast, the Second Circuit accepted the government's

argument.

BNY, 801 F.3d at 121–22.
We

see

no

need

to

address

the

government's

characterization of the Bx payment as a rebate, not income, because
we hold that whether the Bx payment is best characterized as a
rebate or as income, Sovereign's argument still fails.

The STARS

Trust transaction itself does not have a reasonable prospect of
creating a profit without considering the foreign tax credits,
and, as a result, it is not a transaction for which Congress
intended to give the benefit of the foreign tax credit.

This

conclusion mirrors that of the Federal Circuit in Salem, and we
reach it largely for the reasons stated there.
at 946-55.

Salem, 786 F.3d

We agree with that court that we must "assess [the]

transaction's

economic

reality,

and

in

particular

potential, independent of the expected tax benefits."

its

profit

Id. at 948.

Using similar reasoning, we find that the Trust transaction is
"shaped solely by tax-avoidance features," id. at 942 (quoting
Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1375 (Fed.
Cir. 2010)), that "lack a bona fide business purpose," id.

Most

importantly, we agree with the Federal Circuit that the Trust

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transaction is profitless, id. at 949, and that it is "not the
type of transaction Congress intended to promote with the foreign
tax credit system," id. at 954.
The 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 value in U.K. taxes.

To return briefly

to the $100 hypothetical: even if Sovereign receives an $11 Bx
payment from Barclays (half of the $22 paid by Sovereign to the
United Kingdom at its 22% tax rate), the Trust transaction lacks
a reasonable potential (or any potential) of generating profit
because the $11 Bx payment is earned at the expense of the $22
U.K. tax.

In other words, every $1 the Trust transaction earns

through the Bx payment costs $2 from the transaction costs of
subjecting the Trust transaction to U.K. tax.

When the primary

transaction cost of the Bx payment, the U.K. taxes, are factored
into the pre-tax profitability calculation, the Trust transaction
is plainly profitless. 11

Sovereign's "profit" comes from the

11

Because exposure to U.K. taxation was the necessary and
sufficient condition of the Bx payment, the U.K. taxes were an
expense incurred by Sovereign for the "profit" generated by the
Trust transaction.
And when the U.K. taxes are recognized as
expenses, there is no pre-tax profit, and the Trust transaction
lacks a cardinal feature of an economically substantial
transaction: a reasonable prospect of pre-tax profit.
Sovereign and the district court rely heavily on Compaq
and IES for the proposition that foreign taxes should not be
treated as expenses.
Santander II, 144 F. Supp. 3d at 242–44.
Those cases did not analyze STARS transactions and so are
distinguishable factually.
We agree with the Salem court's
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foreign tax credits it claims for the U.K. taxes combined with a
Bx payment calculated as half its U.K. tax liability.
Accordingly,

we

conclude

both

that

the

STARS

Trust

transaction had no objective non-tax economic benefit and that
Congress, in creating the foreign tax credit regime, did not intend
that it would cover this type of generated transaction.12

Exposure

to U.K. taxation for the purpose of generating U.S. foreign tax
credits was the Trust transaction's whole function.
Our conclusion that the Trust transaction lacks economic
substance is entirely consistent with our statement in Dewees that
"taxpayers may lawfully structure transactions that seek real
gains in a way that also maximizes tax advantages."

870 F.2d at

analysis of this issue as to the Trust transaction.
947–49.

786 F.3d at

Nor does our conclusion that Sovereign's U.K. taxes
should be considered expenses contradict the Supreme Court's
holding in Old Colony. Old Colony did not involve foreign taxes
and says nothing about whether foreign tax liability may ever be
considered an expense. See Old Colony, 279 U.S. at 716.
12

See John P. Steines, Jr., Subsidized Foreign Tax Credits
and the Economic Substance Doctrine, 70 Tax Lawyer (forthcoming
2017) ("[I]t is virtually impossible for a dispassionate analyst
to reasonably conclude that Congress intended to surrender more
revenue than that captured by the foreign government in a holistic
sense where the U.S. taxpayer and the counterparty split the
remaining spoils solely by reason of carefully exploited
inconsistent international tax rules in an otherwise unprofitable
transaction that is an overly complicated version of an orthodox
deal that would not have given rise to credits at all."). A copy
of this article was filed with the court and disclosed to the
parties.

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Again, this situation does not involve private parties

structuring an agreement to benefit both parties and only then
seeking to maximize the tax benefits.

The Bx payments do not come

into fruition until and unless Sovereign pays the U.K. taxes (for
which it will seek a 100% credit on its U.S. taxes).
Indeed, the record demonstrates that the Bx payment is
inextricably linked to the deliberate incurring of Sovereign's
U.K. tax liability.

Barclays and Sovereign made clear to each

other that the Bx payment would be calculated based on Sovereign's
U.K. tax liability and the credits that Barclays would then be
able to claim.

An internal communication between the parties

stated that the Bx payment would allow "Barclays [to] share[] U.K.
tax credits with Sovereign."
The STARS scheme is profitable only because Sovereign
plans to obtain U.S. tax credits; that is, the whole existence of
the Trust transaction depends on getting a U.S. tax credit.

There

is otherwise no business reason to engage in the transaction.
the Salem court found:
The evidence thus supports the trial court's
finding that the STARS Trust was a "prepackaged
strategy" created to generate U.S. and U.K. tax benefits
for [the counterparty] and Barclays.
Barclays agreed
to bear half of [the counterparty's] U.K. tax expense
under the transaction in exchange for an opportunity to
claim substantial U.K. tax benefits for itself (through
the trading loss deduction). [The counterparty], on the
other hand, benefited by claiming a foreign tax credit
equal to the entire amount of the Trust's U.K. taxes
while "getting back one-half of the U.K. tax" from

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Barclays.
Absent those tax advantages,
transaction would never have occurred.
786 F.3d at 952 (citation omitted).

the

Entry ID: 6055691

STARS

Here, Sovereign subjected its

property and income to U.K. taxation only because it anticipated
it could avoid U.S. taxes through the resulting U.S. tax credit.
The Trust transaction did not advance the Tax Code's
interest in providing foreign tax credits in order to encourage
business

abroad

or

in

avoiding

double

taxation.

Nor

does

disallowing foreign tax credits for the STARS Trust transaction
interfere with the United Kingdom's authority.

After all, it was

the U.K. authorities who in 2005 first called STARS transactions
to the attention of the IRS as a potential impermissible tax
shelter.13

13

Moreover, there is no tension between denying foreign
tax credits for the STARS Trust transaction and the U.S.-U.K. tax
treaty: As the government correctly notes, the treaty requires the
grant of foreign tax credits "subject to the limitations of the
laws of the United States."
Convention with Great Britain and
Northern Ireland regarding Double Taxation and Prevention of
Fiscal Evasion, art. 24, July 24, 2001, S. Treaty Doc. No. 10719.
Among those limitations, of course, are "anti-abuse
principles" such as the economic substance doctrine. See Treasury
Dep't, Technical Explanation of the Convention Between the
Government of the United States of America and the Government of
the United Kingdom of Great Britain and Northern Ireland for the
Avoidance of Double Taxation and the Prevention of Fiscal Evasion
with Respect to Taxes on Income and on Capital Gains 14. See also
Del Commercial Props., Inc. v. Comm'r, 251 F.3d 210, 214 (D.C.
Cir. 2001) ("[I]f the sole purpose of a transaction with a foreign
corporation is to dodge U.S. taxes, [a] treaty cannot shield the
taxpayer from the fatality of the [substance-over-form] steptransaction doctrine.").

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Of
transactions

course,
that

as

are

Page: 23

the

not

Date Filed: 12/16/2016

government

immediately

readily

Entry ID: 6055691

admits,

profitable

without

some
tax

benefits, such as investments in "nascent technologies," may have
economic substance.

See Salem, 786 F.3d at 950.

But the Trust

transaction is not comparable to such transactions because it does
not "meaningfully alter[] the taxpayer's economic position (other
than with regard to the tax consequences)."

Id.

Moreover, unlike long-term investments that may not
initially turn a profit, but which have economic substance, the
Trust transaction lacks any real economic risk.

The Salem court

pointed out that Barclays ran little risk of having to pay the Bx
payment in absence of the anticipated U.K. tax benefits because
the counterparty indemnified Barclays should that happen.
943–44.
U.K.

tax

Id. at

The Bx payments were not truly independent of the expected
effects.

The

counterparty's

"ability

to

benefit

economically from the Bx payments depended on Barclays'[s] receipt
of its expected tax benefits, which in turn depended on the Trust's
U.K. tax payments."

Id. at 944.

Here, too, Sovereign and Barclays "developed contractual
remedies and took other steps to minimize the risk of [a divergence
between actual effects and the pre-engineered outcome of the Bx
payment's relationship to the U.K. taxes]."

Unlike transactions

that have survived an economic substance challenge, such as the
sale-and-leaseback structure in Frank Lyon, 435 U.S. at 577, the

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STARS Trust transaction posed no non-tax risks to Sovereign.
Instead, Sovereign's internal discussions focused on the "risk" of
being unable to claim foreign tax credits for the U.K. taxes on
the

Trust

transaction,

and

it

informed

the

Federal

Deposit

Insurance Corporation that it would "bear the United States tax
risk" of the transaction.
Further, we agree with the government that Sovereign's
U.K. tax was artificially generated through a series of circular
cash flows through the Trust and was the quid pro quo for the Bx
payment.

The

assets

in

the

Trust

never

effectively

left

Sovereign's control, nor did they perform any function when placed
in the Trust that they could not without the Trust -- other than,
of course, creating the tax effect that made possible the Bx
payment.

Indeed, when calculating the profit potential of the

STARS transaction, Sovereign deducted the income from the Trust
assets, as that income would have been earned without the Trust's
existence.
Resorting to the uncontroversial principle that the
foreign tax credit regime was designed to avoid double taxation
does not help Sovereign.

If mere invocation of that principle

were enough, every tax avoidance scheme would pass muster.

After

all:
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

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economic reality of the transactions, because 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.
Salem, 786 F.3d at 948.
Equally fundamental to the purpose of granting foreign
tax credits is the related principle that those credits are
extended only to legitimate business transactions.

See H.R. Rep.

No. 83-1337, at 4103 (1954) ("The [foreign tax credit] provision
was originally designed to produce uniformity of tax burden among
United States taxpayers, irrespective of whether they were engaged
in business in the United States or engaged in business abroad."
(emphasis added)).
Sovereign.

The Trust transaction provided no business for

It furnished Barclays with a tax benefit, which

Barclays

in

Sovereign

a

turn
tax

shared
benefit

with
of

Sovereign,

its

anticipated foreign tax credits.

own

when

effectively
combined

giving

with

the

The Trust transaction was not a

legitimate business and lacked economic substance.
III.
We reverse the judgment of the district court as to the
economic substance of the Trust transaction and the foreign tax
credits claimed for the Trust transaction and remand for judgment
to be entered for the United States on the refund claim and for a
trial limited to the penalties issue.
appellant.

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Costs are awarded to the