Bank of New York Mellon Corporation, as Successor in Interest to The Bank of New York Company, Inc. v. Commissioner

BANK OF NEW YORK MELLON CORPORATION, AS SUCCESSOR IN
INTEREST TO THE BANK OF NEW YORK COMPANY, INC.,
PETITIONER v. COMMISSIONER OF INTERNAL
REVENUE, RESPONDENT
Docket No. 26683–09. Filed February 11, 2013.

B and its subsidiaries are an affiliated group (Ps). Ps
engaged in a Structured Trust Advantaged Repackaged Secu-
rities transaction (STARS transaction). The STARS trans-
action provided Ps with purportedly below-market-cost
financing from a U.K. bank. As part of the STARS trans-
action, Ps transferred income-producing assets to a trust with
a U.K. trustee and subject to U.K. tax on its income. Ps
claimed foreign tax credits and expense deductions on its 2001
and 2002 Federal consolidated returns in connection with the
STARS transaction. Ps also reported income from the assets
transferred to the trust as foreign source on the consolidated
returns. R determined that the STARS transaction lacked eco-
nomic substance and consequently disallowed the foreign tax
credits, the expense deductions and the reporting of the asset
income as foreign source. Ps contend that the STARS trans-
action had economic substance and that Congress intended
the foreign tax credit to apply to transactions like the STARS
transaction. Held: The STARS transaction lacked economic
substance and is disregarded for Federal tax purposes. Held,
further, because the STARS transaction lacked economic sub-
stance, Ps are not entitled to the claimed foreign tax credits,
the claimed expense deductions or the foreign-source-income
treatment.

15

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 16 140 UNITED STATES TAX COURT REPORTS (15)

B. John Williams, Jr., Alan J.J. Swirski, Julia M. Kazaks,
Cary D. Pugh, Andrew J. McLean, Daniel C. Davis, Melissa
R. Middleton, Shira M. Helstrom, Brendan T. O’Dell, Bryon
Christensen, 1 John Marston, Manoj Viswanathan, Ilana
Yergin, Daniel Davis, and Kristin R. Keeling, for petitioner.
Jill A. Frisch, Curt M. Rubin, Anne O’Brien Hintermeister,
Matthew J. Avon, Justin L. Campolieta, and Michael A.
Sienkiewicz, for respondent.
KROUPA, Judge: Respondent determined deficiencies in
petitioner’s Federal income tax of $100 million 2 and $115
million for 2001 and 2002 (years at issue), respectively.
There are three issues for decision. The first issue is whether
petitioner is entitled to foreign tax credits under section 901 3
claimed in connection with a Structured Trust Advantaged
Repackaged Securities transaction (STARS transaction or
STARS). We hold that petitioner is not because the STARS
transaction lacked economic substance. The second issue is
whether petitioner is entitled to deduct certain expenses
incurred in furtherance of the STARS transaction. We hold
petitioner is not for the same reason. The final issue is
whether income attributed to a trust with a U.K. trustee
used to effect the STARS transaction is U.S. source income
rather than foreign source income. We hold that the income
is U.S. source income. 4

FINDINGS OF FACT

I. Background
Petitioner is a Delaware corporation that maintained its
principal place of business in New York, New York, when it
filed the petition. Petitioner succeeded to the tax liabilities of
The Bank of New York Company, Inc. (BNY Parent) when
1 Bryon Christensen, John Marston, Manoj Viswanathan, Ilana Yergin,

Daniel Davis and Kristin R. Keeling all withdrew as counsel after trial.
2 All monetary amounts have been rounded to the nearest million unless

otherwise indicated.
3 All section references are to the Internal Revenue Code (Code) for the

years at issue, unless otherwise indicated.
4 There is also a question of whether respondent properly adjusted inter-

est expenses allocated to the foreign source income. We need not address
this issue because of our holding that the trust income reported as foreign
source income is U.S. source income.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 17

Mellon Financial Corporation merged with BNY Parent in
2007. BNY Parent was the common parent of an ‘‘affiliated
group’’ (as that term is defined in section 1504(a)) of corpora-
tions that filed consolidated U.S. Federal income tax returns
on an accrual and calendar year basis. The Bank of New
York (BNY) was a wholly owned subsidiary of BNY Parent.
BNY was in the banking business with worldwide banking
operations. Its business activities included taking in deposits,
borrowing money and investing in loans and securities.
The affiliated group through BNY entered into the STARS
transaction in 2001 with Barclays Bank, PLC (Barclays), a
global financial services company headquartered in London,
United Kingdom. The STARS transaction generated approxi-
mately $199 million in foreign tax credits for the combined
years at issue.
II. Introduction and Negotiation of STARS
Barclays and KPMG, an audit, tax and advisory firm,
developed and promoted STARS to U.S. banks. KPMG intro-
duced STARS to BNY during discussions with BNY’s tax
director. Thereafter, tax professionals at KPMG and Barclays
presented STARS to BNY through various meetings, discus-
sions, promotional materials and correspondence.
STARS was represented as a ‘‘below market loan’’ in
KPMG’s initial presentation. KPMG indicated that STARS
required a U.K. counterparty and a certain trust structure
holding income-producing assets. KPMG explained that the
below-market cost would be achieved by the U.K.
counterparty ‘‘sharing’’ U.K. tax benefits from STARS
through an offset to the cost of the loan. Finally, KPMG
indicated that the U.K. tax benefits would be generated by
subjecting income-producing assets held by a trust to U.K.
tax and thus generating foreign tax credits that BNY could
use to offset its U.S. tax liability.
BNY notified KPMG in August 2001 that it was prepared
to move forward with a STARS transaction with Barclays as
the U.K. counterparty. BNY proposed that it would con-
tribute assets that would generate $93 million of annual
U.K. tax costs and expected Barclays to reduce the loan’s
annual cost by half that amount. Shortly thereafter, BNY
agreed to supplement STARS by engaging in a ‘‘stripping

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 18 140 UNITED STATES TAX COURT REPORTS (15)

transaction.’’ The effect would be to accelerate and increase
the tax benefits STARS produced (i.e., foreign tax credits).
And just before STARS closed, BNY indicated to Barclays
that it had decided to increase the targeted benefit.
III. The STARS Transaction
BNY closed the STARS transaction with Barclays in
November 2001. The key components of STARS were as fol-
lows.
A. The STARS Structure
BNY used existing subsidiaries and created special-pur-
pose entities to create a structure (STARS structure) to carry
out the STARS transaction. BNY accomplished this by
engaging in the following steps.
1. Step 1: REIT Holdings Funded
BNY contributed $6.46 billion of assets (BNY assets) to
BNY REIT Holdings, LLC (REIT Holdings), an existing BNY
subsidiary treated as a corporation for U.S. tax purposes.
The BNY assets consisted of participating interests in resi-
dential mortgage loans, commercial mortgage loans and con-
sumer loans (participation interests) and various asset-
backed and agency securities. REIT Holdings assumed $2.55
billion of BNY’s liabilities (BNY liabilities) in connection with
the contribution.
2. Step 2: InvestCo Organized and Funded
BNY organized BNY Investment Holdings (DE), LLC
(InvestCo), as a Delaware limited liability company. InvestCo
elected to be taxed as a corporation for U.S. tax purposes and
was part of BNY’s affiliated group. REIT Holdings capital-
ized InvestCo by contributing $10.409 billion of assets, con-
sisting of the BNY assets and BNY Real Estate Holdings,
LLC’s common stock (the REIT share), with a stated value
of $3.95 billion (collectively, the STARS assets). In exchange,
InvestCo assumed the BNY liabilities and issued a 100%
ownership interest in InvestCo to REIT Holdings.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 19

3. Step 3: DelCo Organized and Funded
BNY organized BNY Delaware Funding (DE), LLC (DelCo),
as a Delaware limited liability company. DelCo elected part-
nership tax treatment for U.S. tax purposes. InvestCo
capitalized DelCo by contributing $9.243 billion worth of the
STARS assets. In exchange, DelCo assumed the BNY liabil-
ities and issued to InvestCo all of its class 1 ordinary shares
(DelCo class 1 shares) worth $65 million and its class 2 ordi-
nary shares (DelCo class 2 shares) worth $6.628 billion.
The DelCo class 1 shares held all the voting rights in
DelCo. The DelCo class 2 shares had the right to receive
approximately 99% of DelCo’s distributions. The holders of
DelCo class 1 shares had the exclusive right to appoint
DelCo’s managers. DelCo’s income was distributable in the
absolute discretion of DelCo’s managers.
4. Step 4: Organization, Funding and Terms of the STARS
Trust
BNY formed the BNY STARS Trust (trust) as a common
law trust. The trust was authorized to issue class A units, a
class B unit, a class C unit and a class D unit (collectively,
the trust units). The trust unit holders were contractually
entitled to monthly distributions in the following order. The
class A unit holders were entitled to 1% of the trust
distributable income. The class D unit holder was entitled to
trust distributable income equal to $25 million × (1-month
LIBOR 5 + 415 basis points (basis points)) × 0.78. The class
B unit holder was entitled to 99% of the remaining distribut-
able income, if the class C unit was in issue, or all remaining
distributable income if the class C unit was not in issue. The
class C unit holder was entitled to the remaining trust
distributable income unless a default occurred.
InvestCo transferred the remaining STARS assets
(approximately $1.2 billion) and the DelCo class 2 shares to
the trust in exchange for the class A units and the class B
unit, which had stated values of $6.3 billion and $1.494 bil-
lion, respectively.
5 ‘‘LIBOR’’
is an acronym for ‘‘London Interbank Offering Rate.’’ See gen-
erally Bank One Corp. v. Commissioner, 120 T.C. 174, 189 (2003), aff ’d in
part, vacated in part and remanded sub nom. J.P. Morgan Chase & Co.
v. Commissioner, 458 F.3d 564 (7th Cir. 2006).

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 20 140 UNITED STATES TAX COURT REPORTS (15)

The initial trustee was BNY, acting through its London
branch (U.S. trustee). The Bank of New York (DE), a wholly-
owned subsidiary of BNY Parent, served as the trust man-
ager. Only the holder of all the class A units could nominate
a replacement trustee.
5. Step 5: Organization and Ownership of NewCo
BNY organized BNY NewCo Funding (DE), LLC (NewCo),
as a Delaware limited liability company, with InvestCo as its
sole member. NewCo elected partnership treatment for U.S.
tax purposes. InvestCo contributed 49% of the class A units
to NewCo in exchange for a membership interest with a
$3.089 billion stated value. This resulted in InvestCo having
a 100% ownership interest in NewCo. InvestCo then distrib-
uted 1% of its NewCo interest to REIT Holdings.
In sum, the above steps moved approximately $7.86 billion
in net assets into DelCo and the trust. The following chart
summarizes steps 1 through 5.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 21

B. The STARS Loan
BNY and Barclays entered into the following agreements
and transactions, the net effect of which was to create a $1.5
billion loan to BNY from Barclays.
1. Class C Unit and Class D Unit Subscription
First, Barclays purchased the class C unit for $1.469 bil-
lion and the class D unit for $25 million from the trust by
a subscription agreement. The subscription agreement
required Barclays to pay further subscription amounts to the
trust equal to the amount of any distributions on the class
C unit. To ensure this, BNY established a blocked account in
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 22 140 UNITED STATES TAX COURT REPORTS (15)

Barclays’ name that Barclays could not access or control
(Barclays blocked account). Also, BNY and Barclays agreed
that all class C unit distributions were to be paid to the
Barclays blocked account, and all further subscription
amounts Barclays owed were to be paid from the Barclays
blocked account.
2. Trust Class C Unit and Class D Unit Forward Sale
Agreements
Second, InvestCo and Barclays entered into a forward sale
agreement obligating InvestCo to purchase the class C unit
(class C unit forward sale agreement) from Barclays in
November 2006, or earlier in the event of default or accelera-
tion, for $1.498 billion. The sale price under the class C unit
forward sale agreement was equal to the $1.475 billion prin-
cipal plus interest compounded annually at 4.338% less a
fixed amount based on the amount of U.K. taxes paid on the
trust income.
Investco and Barclays entered into another forward sale
agreement obligating InvestCo to purchase the class D unit
(class D unit forward sale agreement) from Barclays within
90 days of the purchase by InvestCo of the class C unit, for
$25 million plus any additional amount for any accrued but
unpaid distributions on the class D unit. The sale price
under the class D unit forward sale agreement was the same
as the original subscription price of the class D unit.
3. Zero Coupon Swap
Third, InvestCo and Barclays entered into a zero coupon
swap agreement that required InvestCo to make monthly
payments equal to one-month dollar LIBOR plus 30 basis
points by reference to a $1.475 billion notional amount, less
a spread amount (spread). The spread was a fixed amount
equal to one-half of the present value of the expected U.K.
taxes on the target class C unit income (discussed below)
each month. In exchange for InvestCo’s monthly payments,
Barclays agreed to pay $23 million to InvestCo on the zero
coupon swap maturity date in November 2006. The payment
was designed to equal the amount that exceeded the $1.475
billion InvestCo was obligated to pay under the class C unit
forward sale agreement if it continued in force until its
expiration in November 2006.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 23

4. Guaranty and Security for InvestCo’s Obligations Under
the Forward Sale Agreements and Zero Coupon Swap
a. Guaranty
Barclays and BNY entered into a credit default swap in
November 2001. Under the credit default swap, BNY guaran-
teed all obligations of InvestCo under the forward sale agree-
ments and the zero coupon swap to Barclays in case of
InvestCo’s bankruptcy or default. In exchange, Barclays paid
a fixed rate of 10 basis points on the notional amount of
$1.475 billion.
b. Security Arrangements
To secure InvestCo’s obligations under the forward sale
agreements and the zero coupon swap, the trust and DelCo
each pledged a portion of the STARS assets (consisting of
asset-backed and agency securities) as collateral. The trust
transferred $1.432 billion of securities (trust collateral securi-
ties) to a collateral account, and DelCo transferred $1.166
billion of securities (DelCo collateral securities) to another
collateral account (DelCo securities account). Proceeds from
the securities were held in the same accounts, respectively.
Barclays was granted a security interest in the trust securi-
ties account and the DelCo securities account (collectively,
collateral accounts). BNY acted as the securities inter-
mediary for the assets held in these accounts. BNY guaran-
teed through a participation agreement that the trust and
DelCo together would hold at least $2.25 billion worth of
high-quality securities as collateral for so long as Barclays
held the class C unit.
5. Net Effect of the Subscription Agreements, Forward Sale
Agreements and Zero Coupon Swap
In sum, the forward sale agreements, the zero coupon swap
and the security arrangements converted Barclays’ initial
subscriptions for the class C unit and class D unit into a
secured loan from Barclays to BNY for $1.5 billion at LIBOR
plus 20 basis points (loan). 6 BNY would pay the interest on
6 For
simplicity, we net the zero coupon swap floating leg, the credit de-
fault swap payment and the class D unit distributions in referring to the
Continued

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 24 140 UNITED STATES TAX COURT REPORTS (15)

the loan through the monthly LIBOR-based amounts under
the zero coupon swap, excluding the spread. BNY would
repay the principal through the forward sale prices, net of
the fixed payment of the zero coupon swap.
The following diagram broadly reflects the terms of the
various agreements making up the loan.

C. Use of the STARS Loan Proceeds
The trust immediately redeemed InvestCo’s class B unit
with the $1.494 billion the trust received from Barclays’ pur-
chase of the class C unit and the class D unit. InvestCo then
placed $1.5 billion on deposit with a BNY branch office in the
Cayman Islands (Cayman branch). After an initial 11-day
term, the money was held on deposit at the Cayman branch
in 1-month terms for the duration of STARS. The Cayman
branch booked this deposit as a liability to Barclays.
interest rate (LIBOR plus 20 basis points) on the loan.
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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 25

D. Replacement of the U.S. Trustee
BNY and Barclays replaced the U.S. Trustee with The
Bank of New York Trust and Depositary Company Limited
(U.K. trustee), which was treated as a U.K. resident for U.K.
tax purposes. The U.K. trustee was a wholly-owned sub-
sidiary of BNY parent.
E. The Stripping Transaction
The parties entered into a series of agreements slightly
over a month after STARS closed to accelerate the U.K. taxes
due on trust income by converting periodic cashflows into an
up-front taxable lump-sum payment (stripping transaction).
These agreements contemplated the following steps.
First, BNY would contribute $402 million to DelCo through
REIT Holdings, InvestCo and the trust. Second, the U.K.
trustee would transfer the trust collateral securities to BNY
as ‘‘custodian’’ in exchange for principal-only receipts and
interest-only receipts. Third, DelCo would use the contrib-
uted funds to purchase the interest-only receipts from the
trust for $402 million. Fourth, the collateral arrangements
would be amended so that Barclays obtained a security
interest in the principal-only receipts and the interest-only
receipts.
To effect the stripping transaction, the trust exchanged the
trust collateral securities for the interest-only receipts and
principal-only receipts, which represented beneficial owner-
ship in the interest payments and principal payments,
respectively. DelCo then purchased the interest-only receipts
for $402 million from the trust. The funds used to purchase
the interest-only receipts were not transferred in accordance
with steps contemplated in the transaction documents.
Instead, BNY transferred $402 million directly to the trust’s
bank account.
Barclays was granted a security interest in the principal-
only and interest-only receipts that were transferred to a
trust security account and DelCo security account, respec-
tively.
For U.K. tax purposes, the trustee treated the $402 million
from the sale of the interest-only receipts as taxable income
at the time of the sale. The U.K. trustee was required to pay

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 26 140 UNITED STATES TAX COURT REPORTS (15)

U.K. taxes on the taxable income. Under U.S. tax rules, how-
ever, the trust did not report a gain or loss.
The post-tax income from the stripping transaction was
distributed to the class C unit holder in the next monthly
period. BNY received its benefit, a portion of the spread, over
a period of 14 months.
Net the stripping transaction added $402 million in income
to the trust, over and above the monthly target amount, that
was taxable in the United Kingdom and generated additional
trust taxes and foreign tax credits of $88 million in 2001.
BNY ignored the stripping transaction in managing and
disposing of the stripped securities. When the trust manager
sold a stripped security, the trust manager would reconsti-
tute the security and withdraw it from the collateral pool.
F. Management and Control of Trust Assets and DelCo
Assets
The trust manager held absolute discretion in managing
the trust assets. The trust manager delegated its authority
to BNY through a servicing agreement for which BNY
received a monthly fee. BNY also agreed to manage DelCo’s
assets for a monthly fee and was authorized to take any nec-
essary action.
G. Allocation of STARS Risk
BNY and Barclays also took steps to apportion risk associ-
ated with STARS. These steps are as follows.
1. Trust Class C Target Distributions and Indemnity Pay-
ments for Shortfalls
BNY and Barclays executed agreements to protect against
trust target income shortfalls. The class C unit forward sale
agreement provided that InvestCo would pay an indemnity
amount if any class C unit distribution was less than a cer-
tain target amount for each period ($12 million for period 1,
$338 million for period 2 and $30 million for all other
periods). The class C unit indemnity amount equaled addi-
tional U.K. trust taxes (future valued) that the trust would
pay if it met the target class C unit distribution.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 27

2. STARS Termination Rights
BNY and Barclays also included contractual mechanisms
for each party to terminate the STARS transaction on short
notice. Barclays and InvestCo each had the right, with or
without cause, to accelerate the class C unit or the class D
unit forward sale date by serving a notice of a forward sale
date not less than 5 days nor more than 30 days after the
notice (exit provision).
3. Allocation of U.K. Tax Risk
Additionally, BNY and Barclays agreed to certain provi-
sions allocating U.K. tax risk. BNY agreed under one provi-
sion to pay Barclays half of any trust tax that was refunded
if the U.K. tax authority did not respect Barclays’ U.K. tax
position with respect to the trust. In addition, Barclays and
InvestCo agreed under another provision to indemnify each
other for one-half of any U.K. stamp duty reserve tax
imposed as a result of either forward sale agreement.
IV. U.K. Tax Treatment of STARS
A. Disclosure of STARS to the U.K. Tax Authority
Barclays engaged in transactions substantially similar to
STARS with other U.S. banks. Barclays disclosed one of
those transactions to the U.K. tax authority in June 2001
while it was negotiating STARS with BNY. Barclays dis-
closed the STARS transaction in April 2002 to the U.K. tax
authority. The U.K. tax authority advised Barclays that it
agreed with Barclays’ tax reporting of the STARS transaction
in June 2002. The STARS transaction increased tax revenue
for the United Kingdom.
B. U.K. Tax Treatment of the Trust
The trust was treated as an unauthorized unit trust under
U.K. law that qualified as a collective investment scheme
under the applicable U.K. regulatory laws. When the U.K.
trustee replaced the U.S. trustee, the trust became subject to
U.K. tax as a collective investment scheme for purposes of
U.K. law. As a result, the income arising from the trust
assets was treated as income of the U.K. trustee, which was
subject to a 22% U.K. income tax under section 469 of the
U.K. Income and Corporations Taxes Act 1988. That U.K.

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 28 140 UNITED STATES TAX COURT REPORTS (15)

income tax paid was a liability of the U.K. trustee and not
of any of the trust unit holders. The U.K. trustee owed the
U.K. income tax whether or not the trust made actual dis-
tributions to the trust unit holders.
C. U.K. Tax Treatment of Barclays
Under U.K. law, Barclays, as a trust unit holder, was
deemed to receive annual payments from the trust. Barclays
owed U.K. corporation tax at a 30% rate on those deemed
annual payments even if Barclays did not receive any trust
distributions. The deemed annual payments were equal to
the income available for distribution from the trust to
Barclays as holder of the class C unit and class D unit,
grossed up for 22% U.K. income tax. Barclays was entitled
to a U.K. tax credit of 22% on the deemed annual payment.
Barclays could also claim a U.K. deduction for contributing
the class C unit distributions and for the spread amount paid
to InvestCo through the zero coupon swap.
V. STARS Cashflows
The STARS participants made various payments and
monthly distributions throughout STARS. These payments
and distributions are explained as follows.
A. DelCo Distributions
DelCo held most of the STARS assets at closing. DelCo
made monthly distributions to InvestCo (class 1 shareholder)
and the trust (class 2 shareholder) with InvestCo receiving
1% and the trust receiving the remaining 99%. The monthly
distributions to the trust were sufficient for the trust to meet
the target distributions to Barclays. When DelCo’s income
did not meet projected DelCo distributions, DelCo satisfied
the difference from its cash on hand. BNY also arranged for
the contribution of more income-producing assets to DelCo.
B. Trust Distributions
The trust generated income from the trust assets and
DelCo class 2 distributions. The trust set aside 22% of the
trust income in reserves for U.K. taxes, which were periodi-
cally sent to the U.K. tax authority. The remaining income
was distributed monthly to trust unit holders.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 29

The trust made monthly class C unit distributions to the
Barclays blocked account. Those distributions were approxi-
mately equal to the corresponding target distribution
amounts. Barclays immediately contributed these distribu-
tions to the trust to satisfy its obligation to pay further
subscription amounts. The trust also made the required
monthly class D unit distributions to Barclays. Barclays
retained all of these distributions, totaling $7 million over
the term of STARS.
Finally, the trust made monthly contributions to DelCo of
amounts at least equaling but often substantially exceeding
the corresponding contributed income amount from the
Barclays blocked account starting after the first nine months
of STARS.
C. Zero Coupon Swap and Credit Default Swap Payments
InvestCo or Barclays made monthly payments as required
under the zero coupon swap. LIBOR was 2.09% when STARS
closed and stayed below 3% until almost mid-2005. During
that period, the spread due from Barclays under the zero
coupon swap was greater than the LIBOR plus 30 basis
points amount due from InvestCo. Barclays made net pay-
ments to InvestCo under the zero coupon swap of $12 million
for 2001 and $51 million for 2002. Over the life of STARS,
Barclays made net payments to BNY of $82.6 million under
the floating leg of the zero coupon swap. Additionally,
Barclays made all required payments to BNY under the
credit default swap.
VI. Termination of STARS
STARS wound down and eventually terminated in late
2006 when InvestCo and Barclays fulfilled their obligations
under the forward sale agreements and the zero coupon
swap.
VII. BNY Tax Reporting of STARS
The trust, DelCo and NewCo each filed Forms 1065, U.S.
Return of Partnership Income, for the years at issue. BNY
reported the income from the STARS assets as income on its
U.S. consolidated return. It reported this income, however, as
foreign source. BNY claimed foreign tax credits of

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 30 140 UNITED STATES TAX COURT REPORTS (15)

$98,607,973 and $100,285,767 for 2001 and 2002, respec-
tively, for payments made to the U.K. tax authority with
respect to the trust income.
BNY treated the payments made to Barclays on the class
D unit distributions as a component of interest on the loan.
With respect to the floating leg of the zero coupon swap, BNY
netted the spread component and the LIBOR plus 30 basis
points component of the zero coupon swap. This treatment
effectively resulted in BNY claiming an interest deduction for
the LIBOR plus 30 basis points interest amount (zero coupon
swap interest) for the years at issue as the spread component
exceeded the zero coupon swap interest component for each
year. BNY reduced unrelated interest expense by the net
payments Barclays made to InvestCo under the zero coupon
swap for the years at issue.
BNY claimed $835,100 and $6,753,720 as deductible
expenses, fees and transaction costs for 2001 and 2002,
respectively.
VIII. Deficiency Notice
Respondent timely issued a deficiency notice to petitioner
and adjusted petitioner’s taxable income by disallowing the
foreign tax credits, disallowing deductions for interest and
transaction costs, and reclassifying income related to the
STARS transaction as U.S. source income.

OPINION

This complex transaction presents a case of first impres-
sion in this Court. We are asked to decide whether petitioner
is entitled to foreign tax credits and certain expense deduc-
tions from the STARS transaction and also whether peti-
tioner is entitled to report income generated from the STARS
assets as foreign source income. Respondent argues that the
STARS transaction lacked economic substance. Respondent
asserts consequently that the foreign tax credits and
expenses attributable to STARS should be disallowed and the
income from the STARS assets should be characterized as
U.S. source. 7 Petitioner, in contrast, contends the STARS
7 Respondent also argues that the foreign tax credits BNY claimed are

disallowed under substance over form doctrines (including the step trans-
action doctrine) and under the statutory anti-abuse rule in sec. 269(a). We

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 31

transaction had economic substance. In this regard, peti-
tioner asserts that BNY entered into STARS to obtain low-
cost funding for its banking business and that it reasonably
expected to earn a pre-tax profit from STARS. Additionally,
petitioner contends that the U.S. foreign tax credit was
intended for transactions like STARS.
We agree with respondent. The STARS transaction was
structured to meet the relevant requirements in the Code
and the regulations for claiming the disputed foreign tax
credits. The STARS transaction in essence, however, was an
elaborate series of pre-arranged steps designed as a subter-
fuge for generating, monetizing and transferring the value of
foreign tax credits among the STARS participants. We now
turn to the merits of the STARS transaction under the eco-
nomic substance doctrine.
I. Merits of the STARS Transaction Under the Economic Sub-
stance Doctrine
A. Overview
Taxpayers may structure business transactions in a
manner that results in the least amount of tax. See Boulware
v. United States, 552 U.S. 421, 430 n.7 (2008) (citing Gregory
v. Helvering, 293 U.S. 465, 469 (1935)); Gerdau Macsteel, Inc.
v. Commissioner, 139 T.C. 67, 168 (2012). Courts have also
long recognized, however, that even if a transaction complies
literally with the Code, it does not necessarily follow that
Congress intended to cover the transaction and allow a tax
benefit. Knetsch v. United States, 364 U.S. 361, 365 (1960);
Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff ’d,
293 U.S. 465 (1935). In Frank Lyon Co. v. United States, 435
U.S. 561, 583–584 (1978), the Supreme Court explained the
circumstances in which a transaction should be respected for
tax purposes:
[W]here, as here, there is a genuine multiple-party transaction with eco-
nomic substance which is compelled or encouraged by business or regu-
latory realities, is imbued with tax-independent considerations, and is
not shaped solely by tax-avoidance features that have meaningless labels
attached, the Government should honor the allocation of rights and
duties effectuated by the parties. * * *

need not decide these arguments because of our other holdings.

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 32 140 UNITED STATES TAX COURT REPORTS (15)

The Courts of Appeals have interpreted that language as
creating an ‘‘economic substance doctrine’’ with the following
two prongs: (1) whether the transaction had economic sub-
stance beyond tax benefits (objective prong), and (2) whether
the taxpayer had shown a non-tax business purpose for
entering into the disputed transaction (subjective prong). See
Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. at 169;
Reddam v. Commissioner, T.C. Memo. 2012–106; see also
New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132
T.C. 161, 175 (2009), aff ’d, 408 Fed. Appx. 908 (6th Cir.
2010); Blum v. Commissioner, T.C. Memo. 2012–16.
There is a split among the Courts of Appeals, however, as
to the proper application of the economic substance doctrine,
and alternative approaches have emerged. Some Courts of
Appeals require that a valid transaction have economic sub-
stance or a non-tax business purpose. See, e.g., Horn v.
Commissioner, 968 F.2d 1229, 1236–1238 (D.C. Cir. 1992),
rev’g Fox v. Commissioner, T.C. Memo. 1988–570; Rice’s
Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir.
1985), aff ’g in part, rev’g in part 81 T.C. 184 (1983). Other
Courts of Appeals require a valid transaction have both eco-
nomic substance and a non-tax business purpose. See Dow
Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir.
2006); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d
1313, 1316 (11th Cir. 2001), aff ’g 113 T.C. 254 (1999); United
Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014,
1018 (11th Cir. 2001), rev’g T.C. Memo. 1999–268. Still other
Courts of Appeals adhere to the view that a lack of economic
substance is sufficient to invalidate a transaction regardless
of the taxpayer’s subjective motivation. See, e.g., Coltec
Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir.
2006). And still other Courts of Appeals treat the objective
and subjective prongs merely as factors to consider in deter-
mining whether a transaction has any practical economic
effects beyond tax benefits. See, e.g., ACM P’ship v. Commis-
sioner, 157 F.3d 231, 248 (3d Cir. 1998), aff ’g in part, rev’g
in part T.C. Memo. 1997–115.
An appeal in this case would lie to the Court of Appeals
for the Second Circuit absent stipulation to the contrary,
and, accordingly, we follow the law of that circuit to the
extent it is directly on point. See Golsen v. Commissioner, 54
T.C. 742 (1970), aff ’d, F.2d 985 (10th Cir. 1971). The Court

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 33

of Appeals for the Second Circuit has endorsed applying a
flexible analysis in assessing economic substance. Gilman v.
Commissioner, 933 F.2d 143 (2d Cir. 1991), aff ’g T.C. Memo.
1989–684; Long Term Capital Holdings v. United States, 330
F. Supp. 2d 122 (D. Conn. 2004), aff ’d, 150 Fed. Appx. 40 (2d
Cir. 2005). The analysis evaluates both the subjective busi-
ness purpose of the taxpayer for engaging in the transaction
and the objective economic substance of the transaction.
Gilman v. Commissioner, 933 F.2d at 148; Long Term Cap-
ital Holdings, 330 F. Supp. 2d at 171. These distinct aspects
of the economic substance inquiry do not, however, constitute
discrete prongs of a rigid two-step analysis. Long Term Cap-
ital Holdings, 330 F. Supp. 2d at 171 n.68; see also Gilman
v. Commissioner, 933 F.2d at 148. They are instead simply
more precise factors to consider in the overall inquiry of
whether the transaction had any practical economic effects
other than the creation of tax losses. Altria Grp. Inc. v.
United States, 694 F. Supp. 2d 259, 282 (S.D.N.Y. 2010),
aff ’d, 658 F.3d 276 (2d Cir. 2011); Long Term Capital
Holdings, 330 F. Supp. 2d at 171 n.68. A finding of a lack
of either economic substance or a non-tax business purpose
can be but is not necessarily sufficient for a court to conclude
that a transaction is invalid for Federal tax purposes. Altria
Grp., Inc., 694 F. Supp. 2d at 282; Long Term Capital
Holdings, 330 F. Supp. 2d at 171 n.68. The ultimate deter-
mination of whether a transaction lacks economic substance
is a question of fact. See Nicole Rose Corp. v. Commissioner,
320 F.3d 282, 284 (2d Cir. 2003), aff ’g 117 T.C. 328 (2001).
We now turn to the scope of the economic substance doctrine.
B. Scope of the Economic Substance Inquiry
The first step in the economic substance inquiry is to iden-
tify the transaction to be analyzed. See, e.g., Sala v. United
States, 613 F.3d 1249, 1252 (10th Cir. 2010). Petitioner
argues that we should analyze the components of the STARS
transaction as an integrated arrangement for purposes of
testing economic substance. In contrast, respondent argues
that we should bifurcate the STARS transaction and focus on
the STARS structure, not the loan, for purposes of testing
economic substance. We agree with respondent.
The relevant transaction to be tested is the one that pro-
duces the disputed tax benefit, even if it is part of a larger

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 34 140 UNITED STATES TAX COURT REPORTS (15)

set of transactions or steps. 8 See Nicole Rose Corp. v.
Commissioner, 320 F.3d at 284; Kipnis v. Commissioner, T.C.
Memo. 2012–306; Country Pine Fin., LLC v. Commissioner,
T.C. Memo. 2009–251; Long Term Capital Holdings, 330 F.
Supp. 2d at 183; see also Sala, 613 F.3d at 1252; Klamath
Strategic Inv. Fund v. United States, 568 F.3d 537, 545 (5th
Cir. 2009); Coltec Indus., Inc., 454 F.3d at 1352–1355; Black
& Decker Corp. v. United States, 436 F.3d 431, 436 (4th Cir.
2006); ACM P’ship v. Commissioner, 157 F.3d at 260 n.57.
Stated another way, the requirements of the economic sub-
stance doctrine are not avoided simply by coupling a routine
transaction with a transaction lacking economic substance.
See, e.g., Long Term Capital Holdings, 330 F. Supp. 2d at
183; see also ACM P’ship v. Commissioner, 157 F.3d at 260
n.57. A contrary application would undermine the flexibility
and efficacy of the economic substance doctrine.
Accordingly, we focus our economic substance inquiry on
the transaction that gave rise to the disputed foreign tax
credits. The disputed foreign tax credits were generated by
circulating income through the STARS structure. In contrast,
the loan was not necessary for the STARS structure to
produce the disputed foreign tax credits. It is the use of the
STARS structure then that is relevant and that we test for
economic substance.
C. Economic Substance of the STARS Structure
1. Objective Economic Substance
We first consider whether BNY’s use of the STARS struc-
ture had objective economic substance. The Court of Appeals
for the Second Circuit in evaluating objective economic sub-
stance focuses on whether the relevant transaction created a
reasonable opportunity for economic profit; i.e., profit exclu-
sive of tax benefits. Gilman v. Commissioner, 933 F.2d at
8 Congress
noted when codifying the economic substance doctrine in sec.
7701 in 2010 that under present law courts could ‘‘bifurcate a transaction
in which independent activities with non-tax objectives are combined with
an unrelated item having only tax avoidance objectives to disallow those
tax motivated benefits.’’ Staff of Jt. Comm. on Taxation, Technical Expla-
nation of the Revenue Provisions of the ‘‘Reconcilliaton Act of 2010’’ as
amended, in combination with the ‘‘Patient Protection and Affordable Care
Act’’ 153 & n.352 (J. Comm. Print 2010).

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 35

148; Long Term Capital Holdings, 330 F. Supp. 2d at 172.
Accordingly, we must determine whether use of the STARS
structure created a reasonable opportunity for economic
profit. Respondent argues that it did not. We agree and thus
find that the use of the STARS structure lacked objective
economic substance.
The record reflects that BNY did not have a reasonable
expectation that it would make a non-tax economic profit
from using the STARS structure. First, the STARS structure
did not increase the profitability of the STARS assets in any
way. To the contrary, it reduced their profitability by adding
substantial transaction costs, e.g., professional service fees
and foreign taxes incurred as result of using the STARS
structure. 9
Additionally, the activities or transactions that the STARS
structure was used to engage in did not provide a reasonable
opportunity for economic profit. The STARS structure’s main
activity was to circulate income between itself and Barclays.
Every month, as pre-arranged, DelCo would transfer pre-
determined amounts of income to the trust. Substantially all
of the trust income was distributed to the Barclays blocked
9 We have previously held that foreign taxes are economic costs for pur-

poses of the economic substance doctrine. See Compaq Computer Corp. v.
Commissioner, 113 T.C. 214 (1999), rev’d, 277 F.3d 778, 785 (5th Cir.
2001). We are mindful that the Courts of Appeals for the Fifth and Eighth
Circuits have subsequently held that foreign taxes should not be taken
into account in evaluating pre-tax effects for purposes of the economic sub-
stance analysis. See IES Indus., Inc. v. United States, 253 F.3d 350 (8th
Cir. 2001); Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 785
(5th Cir. 2001), rev’g 113 T.C. 214 (1999). Nevertheless, the Supreme Court
and the Court of Appeals for the Second Circuit have yet to consider the
issue, and we are not bound by Fifth and Eighth Circuit precedent here.
We maintain the position we took in Compaq Computer with respect to
foreign taxes in the economic substance context. Economically, foreign
taxes are the same as any other transaction cost. And we cannot find any
conclusive reason for treating them differently here, especially because
substantially all of the foreign taxes giving rise to the foreign tax credits
stemmed from economically meaningless activity, i.e., the pre-arranged cir-
cular cashflows engaged in by the trust.
Additionally, excluding the economic effect of foreign taxes from the pre-
tax analysis would fundamentally undermine the point of the economic
substance inquiry. That point is to remove the challenged tax benefit and
evaluate whether the relevant transaction makes economic sense. See In
re CM Holdings, Inc., 301 F.3d 96, 105 (3d Cir. 2002).

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 36 140 UNITED STATES TAX COURT REPORTS (15)

account, which in turn was immediately recontributed to the
trust and then passed back to DelCo where it was available
for BNY’s use. These circular cashflows or offsetting pay-
ments had no non-tax economic effect.
Courts have consistently recognized that the presence of
circular cashflows strongly indicates that a transaction lacks
economic substance. See Altria Grp., Inc., 658 F.3d at 289
(citing AWG Leasing Trust v. United States, 592 F. Supp. 2d
953, 983 (N.D. Ohio 2008)) (circular payments from and back
to foreign bank ‘‘strongly indicate’’ that SILO transaction
‘‘has little substantive business purpose other than gener-
ating tax benefits’’); Merryman v. Commissioner, 873 F.2d
879, 882 (5th Cir. 1989) (tax structuring disregarded where
‘‘money flowed back and forth but the economic positions of
the parties were not altered’’), aff ’g T.C. Memo. 1988–72;
Prof ’l Servs. v. Commissioner, 79 T.C. 888, 928 (1982) (dis-
regarding pre-arranged circular cashflows through a trust);
see also Knetsch, 364 U.S. at 366 (offsetting payments on
annuity bond and notes resulted in sham). This follows from
the common sense proposition that a taxpayer is not entitled
to benefits from circular transfers the net result of which is
effectively nothing.
The STARS structure was also used in connection with the
stripping transaction. The stripping transaction too resulted
in a circular cashflow and did not provide a reasonable
opportunity for economic profit. In particular, the trust sold
its right to interest income from the trust collateral securi-
ties to DelCo for a lump-sum payment taxable in the United
Kingdom, which DelCo made with funds provided by BNY.
This reallocated the income and principal payments associ-
ated with the trust collateral securities within the STARS
structure. It did not alter the amount and timing of the
cashflows generated by the underlying assets. And because
the sale of the interest rights was funded by BNY and
between entities within the STARS structure, the stripping
transaction had no potential to generate a non-tax economic
profit on the aggregate.
Petitioner argues that we should consider the income gen-
erated by the STARS assets in evaluating whether the
STARS structure had a reasonable opportunity for economic
profit. We disagree. Economic benefits that would result
independent of a transaction do not constitute a non-tax ben-

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 37

efit for purposes of testing its economic substance. See
Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. at 174.
Stated otherwise, benefits that are unrelated to the trans-
action cannot be what motivates a taxpayer to engage in the
transaction and therefore are of no aid in determining
whether the taxpayer would have engaged in the transaction
absent the tax effects. Id.
Here, BNY’s control and management over the STARS
assets did not materially change as a result of their transfer
to the STARS structure. 10 Additionally, the STARS structure
had no effect on the income stream generated by the STARS
assets. Accordingly, the STARS assets would have generated
the same income regardless of being transferred to the trust.
Thus, income from the STARS assets was not an incremental
benefit of STARS.
2. Subjective Economic Substance
We now turn to the subjective prong of the economic sub-
stance analysis. This prong requires us to determine whether
BNY had a legitimate non-tax business purpose for the use
of the STARS structure. See Long Term Capital Holdings,
330 F. Supp. 2d at 186. We find it did not. Petitioner claims
that it used the STARS structure to obtain ‘‘low cost
financing’’ from Barclays. 11 The record does not support peti-
tioner’s claimed business purpose. The STARS structure
lacked any reasonable relationship to the loan. And the loan
was not ‘‘low cost.’’ To the contrary, it was significantly over-
priced and required BNY to incur substantially more trans-
action costs than a similar financing available in the market-
place. We find that petitioner failed to establish a valid busi-
10 DelCoheld most of the income-generating STARS assets with the
trust holding the remaining STARS assets. BNY directly or indirectly held
all the voting rights of DelCo, the initial and successor trustee of the trust
and the trust manager, and thus effectively controlled those entities. In ad-
dition, BNY executed servicing agreements that gave BNY control over the
management of the STARS assets the trust and DelCo held.
11 Petitioner’s experts opined on several other potential business pur-

poses at trial. The record does not support, however, that BNY con-
templated those suggested business purposes at the time it participated in
STARS. We therefore reject these after-the-fact rationalizations. See, e.g.,
Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, 285–286 (1999),
aff ’d, 254 F.3d 1313 (11th Cir. 2001).

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 38 140 UNITED STATES TAX COURT REPORTS (15)

ness purpose and BNY’s true motivation was tax avoidance.
We base our finding on our analysis of the following factors.
a. The STARS Structure Lacked a Reasonable Relationship
to Petitioner’s Claimed Business Purpose.
Using unreasonable means to achieve a claimed business
purpose indicates that the taxpayer’s true motivation for the
transaction is tax avoidance. See Long Term Capital
Holdings, 330 F. Supp. 2d at 186–187; see also Cherin v.
Commissioner, 89 T.C. 986, 993–994 (1987); CMA Consol.,
Inc. & Subs. v. Commissioner, T.C. Memo. 2005–16. We now
consider the relationship between the STARS structure and
petitioner’s claimed business purpose. Petitioner suggests
that the class C unit and the class D unit Barclays held
served as collateral for the loan. We are not persuaded.
BNY’s obligation with respect to the loan was more than
adequately secured by other arrangements independent of
the trust. Barclays held a security interest in a pool of high-
quality assets valued at $2.25 billion, creating a
collateralization level of 150%. Respondent’s expert Steven
Schwarcz concluded that the collateralization level (e.g.,
securitization) in a structured finance transaction is usually
around 10% and that the loan was substantially over
collateralized. In addition to the collateral arrangements,
Barclays effectively had full recourse to BNY itself for repay-
ment through the credit default swap.
Petitioner’s expert W. Clifford Atherton suggested that the
special-purpose entities making up the STARS structure
served a project financing (a type of structured financing
transaction) function. We disagree. Respondent’s expert Mr.
Schwarcz emphasized that special-purpose entities are typi-
cally used in connection with a structured financing trans-
action to efficiently reallocate risk and reduce information
asymmetry. 12 Mr. Schwarcz also highlighted that structured
financing transactions generally involve special-purpose enti-
ties incurring debt and using the proceeds to finance the
12 Mr. Schwarcz defined ‘‘information asymmetry’’ as a scenario in which

one party has more information than the other party. According to Mr.
Schwarcz, structured financing transactions reduce information asymmetry
by allowing parties taking on risk to more efficiently assess that risk, typi-
cally by creating well-defined, easily-valued and bankruptcy-protected
sources of repayment.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 39

acquisition of income-producing assets. And the lenders look
to the cash produced by those assets for repayment, bearing
the risk that the cash will be insufficient to repay the debt.
These common indicia of a structured financing transaction
are not present in STARS. The loan proceeds were not used
to purchase the STARS assets, and Barclays did not look to
any assets purchased with the financing proceeds for repay-
ment. And unlike a typical structured financing transaction,
the special-purpose entities in STARS did not function to effi-
ciently reallocate risk.
In this regard, Mr. Schwarcz observed that STARS simply
involved a full-recourse secured financing. Mr. Schwarcz cor-
rectly concluded that, given the characteristics of the loan,
Barclays could have made the same $1.5 billion loan to BNY,
secured by the same assets constituting the collateral for the
loan, using only a loan agreement and a security agreement.
Such an arrangement would have been much simpler,
avoided the use of the special-purpose entities and had
substantially lower transaction costs than STARS.
Efficiency aside, Mr. Schwarcz concluded that the special-
purpose entities used in the STARS transaction did not ‘‘real-
istically’’ function to transfer risk between the parties. Mr.
Schwarcz opined that the overcollateralization level of the
loan and the other security arrangements minimized
Barclays’ risk with respect to the loan. Accordingly, there
was no significant risk for the special-purpose entities to
transfer.
Finally, Mr. Schwarcz concluded that the STARS structure
did not reduce information asymmetry between the parties.
In contrast, he opined that STARS was excessively complex
given the economics of the loan and arguably increased
information asymmetry. We agree with Mr. Schwarcz that
the STARS structure did not perform a structured financing
function.
Petitioner finally argues more generally that Barclays
made the loan contingent on the STARS structure and there-
fore the two transactions were ‘‘commercially linked.’’ Again,
we are not persuaded. Making a routine business transaction
contingent on an economically meaningless transaction, like
the STARS structure, is insufficient to establish that the
nexus between the two is reasonable. See, e.g., Long Term
Capital Holdings, 330 F. Supp. 2d at 183.

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 40 140 UNITED STATES TAX COURT REPORTS (15)

In sum, the record does not support that the STARS struc-
ture performed any significant banking, commercial or busi-
ness function with respect to the loan. Consequently, we find
that the STARS structure did not bear a reasonable relation-
ship to the loan. This lack of reasonableness indicates BNY’s
true motivation—tax avoidance.
b. The STARS Financing Was Not Low Cost.
We now evaluate petitioner’s claimed business purpose
that the loan was ‘‘low cost.’’ Respondent argues that the
spread should be disregarded in determining the cost of the
loan and that the loan was overpriced absent the spread. We
address each of respondent’s contentions in turn.
i. The Spread Was Not a Component of Interest.
We now consider whether the spread should be disregarded
in determining the cost of the loan. Respondent argues that
it should because the spread in substance was a tax effect
and not a component of interest. We agree.
We are mindful in evaluating the substance of the spread
that labels and characterizations do not determine the tax
consequences where they are inconsistent with economic
realities. Frank Lyon Co., 435 U.S. at 583–584 (labels must
be economically meaningful); TIFD III–E, Inc. v. United
States, 459 F.3d 220 (2d Cir. 2006); Saba P’ship v. Commis-
sioner, T.C. Memo. 2003–31 (payments characterized as con-
sulting fees held to be a guaranteed return to a purported
partner).
The stated interest rate on the loan was LIBOR plus 30
basis points less the spread. The spread was a fixed amount
equal to one-half the present value of the U.K. taxes the
trust was expected to pay on the target class C unit income
each month. We acknowledge the spread was part of the for-
mula for calculating the interest expense on the loan. Its
substance did not match, however, its form.
Respondent’s expert Anthony Saunders opined on the
commerciality of the loan’s pricing. Mr. Saunders noted that
the pricing of a loan generally depends on the time value of
money and the risks presented to the lender through the par-
ticular loan transaction. Mr. Saunders also noted that here
the loan’s cost was such that Barclays could not reasonably
expect that the return (i.e., interest) it received from BNY

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 41

would exceed Barclays’ cost of funds. He further noted that,
independent of Barclays’ cost of funds, the interest rate was
‘‘negative’’ for most of the tenure of the loan. That is, the
‘‘lender’’ (Barclays) was paying the ‘‘borrower’’ (BNY) to bor-
row its funds. Mr. Saunders concluded that the loan’s pricing
did not reflect the risk inherent in the STARS transaction
and more generally that the loan fundamentally deviated
from attributes of a standard banking transaction. He fur-
ther concluded that there were no unique economic condi-
tions that might explain the non-economic pricing.
Respondent’s expert Mr. Schwarcz also opined on the
commerciality of the loan. Like Mr. Saunders, Mr. Schwarcz
noted that the loan had a ‘‘negative interest rate.’’ Mr.
Schwarcz opined that, in an arm’s-length commercial lending
transaction, a loan would not bear a negative interest rate,
absent unique circumstances external to the loan, e.g., to
avoid a loss or to effect government policy, such as stimulus.
He noted that it makes no economic sense for a lender to pay
a borrower interest on a loan absent such a circumstance. He
concluded there were no special circumstances that war-
ranted the loan bearing a ‘‘negative interest rate’’ and the
loan was not commercially reasonable.
Respondent’s expert Michael Cragg analyzed the pricing of
the loan, including the economics of the spread. He concluded
that circulating income through the STARS structure gen-
erated the economic benefit labeled the ‘‘spread’’ by com-
bining certain U.S. and U.K. tax effects. Mr. Cragg’s analysis
showed that it would not have been economically beneficial
for Barclays to pay BNY the spread absent the U.K. tax
benefits from STARS. Similarly, Mr. Cragg’s analysis showed
that the STARS arrangement would not have been beneficial
to BNY absent the foreign tax credits arising from the pay-
ment of U.K. tax on the trust income. Mr. Cragg ultimately
concluded that the spread was economically derived and
contingent on the parties receiving certain U.S. and U.K. tax
treatment with respect to the STARS structure and as a
result was not a pre-tax cashflow.
Petitioner denies that the spread was a tax effect because
it was not expressly contingent on either Barclays or BNY
receiving any particular U.S. or U.K. tax treatment or ben-
efit. In this regard, petitioner asserts that BNY could under
certain circumstances keep the spread Barclays paid even if

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 42 140 UNITED STATES TAX COURT REPORTS (15)

Barclays did not realize its expected U.K. benefits. 13 And
petitioner asserts that Barclays’ obligation to pay the spread
did not vary depending on whether BNY’s U.S. tax treatment
was respected.
Petitioner’s argument is unpersuasive. The manner in
which the parties agreed to allocate tax risk does not pre-
clude the spread from being a tax effect. The spread’s value
was derivative of expected U.S. and U.K. tax effects. And it
would not have been paid going forward if either of those
effects had been foreclosed. Indeed, STARS would no longer
be economically beneficial to either BNY or Barclays and
each could terminate STARS on short notice. 14
In sum, we agree with respondent’s experts. The spread
artificially reduced the loan’s cost and lacked economic
reality. In substance the spread was contingent on the par-
ties’ anticipated tax treatment and was unrelated to the time
value of money or the attendant risks associated with the
loan. We conclude, on the record as a whole, that the spread
was in substance not a component of loan interest.
13 If the U.K. tax authority determined that the trust was not a collec-

tive investment scheme before the due date of the U.K. trust tax, BNY
could keep the spread paid to date even though Barclays would not realize
the anticipated U.K. tax benefits. After the first due date of U.K. tax on
trust income, however, BNY was obligated to pay Barclays half of any
STARS trust tax that would be refunded if the U.K. tax authority did not
respect Barclays’ tax position with respect to the STARS structure. That
amount would be roughly equal to spread payments BNY had received.
We note that the risk of having to pay the spread before the first due
date without realizing the anticipated U.K. benefits was likely minimal.
According to petitioner’s U.K. regulatory expert, Michael Brindle, Q.C., the
U.K. tax authority would likely view the STARS structure as a collective
investment scheme. In addition, the STARS structure was promptly sub-
mitted to the U.K. tax authority for approval and a similar transaction
was already under review. And on net the STARS transaction added rev-
enue to the U.K. relative to its position without the STARS transaction,
increasing the likelihood that the U.K. tax authority would view the
STARS structure favorably.
14 Petitioner concedes that Barclays agreed to pay the spread based upon

expected U.K. tax benefits and that the spread was calculated as a per-
centage of the present value of those benefits. Those U.K. tax benefits de-
pended on the vitality of the trust structure whose economic rationality for
BNY depended on BNY receiving a U.S. foreign tax credit for U.K. tax
paid on trust income as the spread equaled only half of the U.K. tax. Ac-
cordingly, Barclays’ U.K. tax benefit could not be achieved without BNY
achieving its U.S. tax benefit.

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 43

The spread rather was a tax effect. It was embedded in the
loan to serve as a device for monetizing and transferring the
value of anticipated foreign tax credits generated from
routing income through the STARS structure. That the gen-
erated tax savings were used to offset the cost of the loan
does not provide a valid non-tax purpose. Indeed, courts have
consistently recognized that intending to use tax savings
from a transaction lacking economic substance to underwrite
or enhance the commercial terms of a legitimate business
transaction does not constitute a valid non-tax purpose. See
Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 287; see
also Am. Elec. Power Co., Inc. v. United States, 326 F.3d 737,
744 (6th Cir. 2003) (‘‘Money generated by means of abusive
tax deductions can always be applied to beneficial causes, but
the eventual use of the money thus generated is not part of
the economic sham analysis.’’).
ii. The Loan Was Not Low Cost.
We now turn to respondent’s contention the loan was not
‘‘low cost’’ absent the spread. Mr. Cragg compared the loan
to available market financing. He opined that the loan was
a secured, highly collateralized loan, cancellable within 5 to
30 days. He further opined that comparable short-term
financing, both secured and unsecured, for a borrower similar
to BNY is typically obtained through highly efficient and
standardized interbank relationships at or below an interest
rate of 1-month LIBOR and de minimis transaction costs
(market benchmark loan). Absent the spread adjustment, the
loan’s interest rate (LIBOR plus 20 basis points) was above
the market benchmark loan. Beyond the additional interest
expense, the loan required BNY to incur substantial trans-
action costs in the form of professional service fees and for-
eign taxes that would not exist in a comparable market
financing. 15 In short, BNY could have obtained comparable
financing in the market place at substantially less economic
cost than that obtained through STARS. We find that the
loan was not ‘‘low cost.’’
15 We note that, regardless of how the spread is characterized, the ben-

efit of the spread was more than offset by the additional transaction costs
that BNY incurred to obtain the spread.

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 44 140 UNITED STATES TAX COURT REPORTS (15)

D. Economic Substance of the Integrated STARS Arrange-
ment
The STARS transaction still lacks economic substance even
if the STARS structure and the loan are evaluated as an
integrated transaction. Petitioner contends that the
integrated STARS transaction has objective economic sub-
stance because it offered a reasonable opportunity for pre-tax
profit. Petitioner asked its expert Mr. Atherton to calculate
the pre-tax profitability of the STARS transaction. Mr. Ath-
erton concluded that BNY reasonably could have expected a
profit of more than $1.6 billion before taking into account
U.K. or U.S. income taxes over the life of the STARS trans-
action.
We find that Mr. Atherton’s analysis of STARS’ pre-tax
profitability contains several critical flaws and is therefore
not helpful to the Court. One such flaw with Mr. Atherton’s
pre-tax profitability calculation is that he includes income
from the STARS assets as revenues arising from the STARS
transaction. As we previously held, the pre-existing cashflows
from the trust assets are not incremental to the STARS
transaction and therefore irrelevant to the objective economic
substance analysis.
Mr. Atherton’s pre-tax profitability analysis is also flawed
because he includes returns on asset-backed securities he
assumes BNY contemplated acquiring with the loan pro-
ceeds. Only cashflows arising from the transaction whose eco-
nomic substance is at issue are relevant to the pre-tax profit-
ability analysis. See Nicole Rose Corp. v. Commissioner, 320
F.3d at 284 (rejecting the taxpayer’s argument that profits
from an unrelated asset sale should be attributed to a lease
transaction generating the tax benefits at issue); ACM P’ship
v. Commissioner, 157 F.3d at 260 (disregarding profits from
funds acquired in a transaction and invested outside of the
structure being evaluated for economic substance); see also
Kipnis v. Commissioner, T.C. Memo. 2012–306 (economic
substance should be reviewed without reference to expected
profit from an intended real estate investment that the tax-
payer expected to make with proceeds from the ‘‘CARDS’’
transaction); Long Term Capital Holdings, 330 F. Supp. 2d
at 183 (requirements of economic substance are not avoided
by coupling a routine profitable economic transaction with no

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 45

inherent tax benefits to a unique transaction that otherwise
lacks profit potential).
Here, the integrated STARS transaction’s net pre-tax effect
was to create a $1.5 billion loan at LIBOR plus 20 basis
points. It did not generate any revenue, only an obligation to
repay the loan principal and interest. Any income from
investing the loan proceeds was not a cashflow arising from
the integrated STARS transaction. Rather, it resulted from a
separate and distinct transaction. Thus, income from
investing the loan proceeds is not relevant to the economic
substance analysis of the integrated STARS transaction and
should have been excluded from the pre-tax profitability
analysis. We note that even if the projected yield on the loan
proceeds Mr. Atherton assumed was relevant that yield is
insufficient to offset the foreign tax costs 16 of the trans-
action.
The last critical flaw in his analysis is his including the
spread in calculating the cost of the loan, the effect of which
is to reduce the cost. As we previously found, the spread is
a tax effect of the STARS structure and its value is effec-
tively funded by the foreign tax credits. Mr. Atherton there-
fore should not have reduced the cost of the loan by the
spread in his pre-tax profitability analysis.
Mr. Atherton’s analysis substantially inflates pre-tax
income by including the non-incremental income from the
STARS assets, the projected yield from the loan proceeds and
the spread as pre-tax income. When these items are omitted,
all that remains is the loan at LIBOR plus 20 basis points.
As we previously discussed, Mr. Cragg’s analysis shows that
the loan was overpriced and therefore not profitable on a pre-
tax basis. Mr. Cragg concluded more generally that it would
have been economically irrational for BNY to enter into the
integrated STARS transaction without the foreign tax credits
BNY derived from it. Accordingly, we find that the integrated
STARS transaction lacks economic substance.
We now address the subjective economic substance of the
integrated STARS transaction. Here, petitioner argues that it
was motivated to enter the STARS transaction to obtain ‘‘low
cost’’ financing. As we previously held, we reject that busi-
ness purpose because it lacks merit. Aside from that claimed
16 See supra note 9.

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 46 140 UNITED STATES TAX COURT REPORTS (15)

business purpose, petitioner contends it was motivated to
enter into STARS by a realistic expectation of pre-tax profit.
Specifically, petitioner claims that BNY intended to use the
loan proceeds to grow its ‘‘investment portfolio’’ and earn a
profit by investing in asset-backed securities. As we pre-
viously held, any income from the investment of the loan pro-
ceeds is not income from the integrated STARS transaction
and therefore is irrelevant to the objective economic sub-
stance analysis. Similarly, any profit petitioner expected to
earn from investing the loan proceeds is not relevant to the
subjective economic substance analysis. 17
E. Congressional Intent
We now consider whether the disputed tax benefits are
what Congress intended in establishing the foreign tax
credit. Petitioner contends that the economic substance doc-
trine does not warrant disallowing the disputed tax benefits
because Congress intended the foreign tax credit for trans-
actions like STARS. We disagree.
The United States taxes income of its citizens, residents
and domestic entities on a worldwide basis. A U.S. corpora-
tion must include foreign source income in its U.S. taxable
income even though that income may also be subject to for-
eign tax. Congress enacted the foreign tax credit to alleviate
double taxation arising from foreign business operations. See
United States v. Goodyear Tire & Rubber Co., 493 U.S. 132,
139 (1989); Am. Chicle Co. v. United States, 316 U.S. 450,
451 (1942); Burnet v. Chicago Portrait Co., 285 U.S. 1, 7
(1932). Congress intended the foreign tax credit to neutralize
the effect of U.S. tax on the business decision of where to
conduct business activities most productively. 56 Cong. Rec.
App. 677–678 (1918) (statement of Rep. Kitchin). The enact-
ment of the foreign tax credit was also informed by fairness.
See National Foreign Trade Council, Inc., International Tax
Policy for the 21st Century (Dec. 15, 2001).
17 We note that petitioner failed to substantiate the claimed business

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

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 (15) BANK OF N.Y. MELLON CORP. v. COMMISSIONER 47

The STARS transaction was a complicated scheme cen-
tered around arbitraging domestic and foreign tax law
inconsistencies. The U.K. taxes at issue did not arise from
any substantive foreign activity. Indeed, they were produced
through pre-arranged circular flows from assets held, con-
trolled and managed within the United States. We conclude
that Congress did not intend to provide foreign tax credits for
transactions such as STARS.
II. Deductibility of STARS-Related Expenses
We now consider whether petitioner is entitled to deduct
expenses incurred in furtherance of STARS. Petitioner con-
tends that it is entitled to deduct the claimed transactional
expenses and the zero coupon swap interest for 2001 and
2002, and petitioner asks the Court to hold that the U.K.
taxes paid on trust income are deductible if we deny the for-
eign tax credits claimed for those taxes. Respondent counters
that the claimed transactional expenses and the U.K. taxes
are not deductible because the STARS transaction lacked
economic substance as we found. We agree.
Expenses incurred in furtherance of a transaction that is
disregarded for a lack of economic substance are not deduct-
ible. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at
294 (observing that ‘‘a transaction that lacks economic sub-
stance is not recognized for Federal tax purposes’’ and that
‘‘denial of recognition means that such a transaction cannot
be the basis for a deductible expense’’); see also Gerdau
Macsteel, Inc. v. Commissioner, 139 T.C. at 182–183. The
claimed transactional expenses, the zero coupon swap
interest expense and the U.K. taxes were all incurred in fur-
therance of the STARS transaction, which we previously held
lacks economic substance. Consequently, they are not deduct-
ible.
III. Foreign Source Income Adjustment
We next address respondent’s adjustment to BNY’s foreign
source income. Petitioner reported the income from the trust
assets as foreign source income based on a ‘‘resourcing’’
provision in paragraph 3 of article 23 of the Convention for
the Avoidance of Double Taxation and the Prevention of
Fiscal Evasion with Respect to Taxes on Income and Capital

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 48 140 UNITED STATES TAX COURT REPORTS (15)

Gains, U.S.–U.K., Dec. 31, 1975, 31 U.S.T. 5668 (U.S.–U.K.
tax treaty).
Petitioner contends that the resourcing provision applies
and that respondent’s foreign source income adjustment was
improper. We disagree. U.S. tax laws and treaties do not rec-
ognize sham transactions or transactions that have no eco-
nomic substance as valid for tax purposes. Del Commercial
Props., Inc. v. Commissioner, T.C. Memo. 1999–411 (citing
Gregory v. Helvering, 293 U.S. 465, 470 (1935), and
Johansson v. United States, 336 F.2d 809, 813 (5th Cir.
1964)), aff ’d, 251 F.3d 210 (D.C. Cir. 2001). Because we pre-
viously held that the STARS transaction is disregarded for
U.S. tax purposes, BNY is treated for U.S. tax purposes as
owning the STARS assets and the income is treated as being
derived by BNY within the United States. Consequently, the
U.S.–U.K. tax treaty, including the resourcing provision, does
not apply. We therefore sustain respondent’s adjustment of
petitioner’s foreign source income.
IV. Conclusion
In sum, the STARS transaction (bifurcated or integrated)
lacks economic substance and Congress did not otherwise
intend to provide foreign tax credits for transactions such as
STARS. Accordingly, the STARS transaction is invalid for
Federal tax purposes and the foreign tax credits and expense
deductions claimed in connection with it are disallowed.
We have considered all remaining arguments the parties
made and, to the extent not addressed, we find them to be
irrelevant, moot or meritless.
To reflect the foregoing,
Decision will be entered for respondent.

f

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