Salem Financial, Inc. Ex Rel. Branch Investments LLC v. United States
2015 U.S. App. LEXIS 7925
| Fed. Cir. | 2015Background
- BB&T (Salem Financial), a U.S. bank, entered a STARS transaction with Barclays (U.K.) from 2002–2007: BB&T contributed U.S. income-producing assets to a U.K. trust and Barclays provided a $1.5 billion financing element.
- The Trust was U.K.-tax resident; BB&T paid the Trust’s U.K. taxes, claimed U.S. foreign tax credits, and received monthly “Bx” payments from Barclays equal to 51% of the Trust’s U.K. taxes. Cash circulations (including a “blocked account”) enabled Barclays to claim U.K. trading-loss deductions and other U.K. tax benefits.
- IRS audited and disallowed nearly $498 million in foreign tax credits, disallowed interest deductions (~$75 million), imposed additional tax (~$84 million) and assessed accuracy-related penalties (~$113 million). BB&T sued for refund; the Court of Federal Claims denied relief under the economic substance (sham) doctrine.
- On appeal the Federal Circuit treated the Trust and Loan components separately: it affirmed disallowance of foreign tax credits for the Trust (lacking economic substance and bona fide business purpose), reversed as to the Loan interest deductions (Loan had economic substance), and remanded penalty calculations.
- Key contractual features: indemnity provisions linking Barclays’ realized U.K. benefits to BB&T’s net receipt of Bx payments; Sidley and KPMG involvement (alleged conflicts); PwC provided audit comfort but not a tax opinion.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Characterization of Bx payments (income vs. tax rebate) | Bx is not a tax rebate under §901(i)/regulations and thus should be income, ending inquiry at statute/regulation | Bx is in substance a rebate of U.K. taxes (tax effect) and should not be treated as income | Bx payments are income to BB&T under Old Colony; economic-substance analysis still applies despite regulatory "substance-over-form" language |
| Economic substance of the STARS Trust (foreign tax credits) | Trust produced income (Bx) and complied literally with §901; credits should be allowed | Trust is a sham—circular cash flows and designed solely to generate foreign tax credits; statutory/substantive inquiry warranted | Trust lacks economic reality and bona fide business purpose; foreign tax credits disallowed (tax consequences disregarded) |
| Economic substance of the STARS Loan (interest deductions) | Loan interest deductible; loan provided real financing and access to $1.5B | Loan was sham financing, overpriced, and merely camouflaged the Bx payment—interest deductions should be disallowed | Loan had economic substance and a non-tax business purpose (legitimate financing); interest deductions allowed |
| Accuracy-related penalties under §6662 | Reliance on Sidley and PwC made position reasonable; law uncertain in this area | Reliance unreasonable: Sidley had conflict of interest; PwC did not provide a tax opinion; transaction was "too good to be true" | Penalties upheld: taxpayer failed to show reasonable cause/good faith; remand required to recompute amounts given loan-interest ruling |
Key Cases Cited
- Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (holding third‑party payment of taxpayer’s taxes constitutes income)
- Frank Lyon Co. v. United States, 435 U.S. 561 (economic substance/business purpose inquiry and respecting form where real economic effects exist)
- Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006) (economic substance is prerequisite to statutory tax benefits; objective economic-reality inquiry)
- Stobie Creek Invs. LLC v. United States, 608 F.3d 1366 (Fed. Cir. 2010) (distinguishing legitimate business-structured transactions from tax-only shams)
- Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001) (analyzing pre-tax benefit and treatment of gross dividend vs. net dividend in foreign tax credit arbitrage cases)
- IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir. 2001) (similar treatment to Compaq on foreign-tax-arbitrage transactions)
- Knetsch v. United States, 364 U.S. 361 (sham/fiction doctrine where transaction produced no substance other than tax benefits)
- Kerman v. Commissioner, 713 F.3d 849 (6th Cir. 2013) (examining loan transactions with unreasonable economics; assessing profit prospects and sham inquiry)