In Uncategorized on 09/23/2013 at 20:41

But Even If You Do, You Can Deduct The Interest

Too many players on the ice, when Bank of New York Mellon Corporation, As Successor In Interest To The Bank of New York Company, Inc., 2013 T. C. Memo. 225, filed 9/23/13, fields fifteen (count ‘em, fifteen!) lawyers against only six for the IRS. Guess that sequester really hurts, guys. But six of those fifteen Mellon lawyers leave after the trial.

At the close of play,  the point of Judge Kroupa’s Supplemental Memorandum Opinion is about borrowing, and the consequences of a deal lacking in economic substance. You may remember Mellon got slugged when they played Barclays Bank’s famous STARS game. See my blogpost “STARS Fell”, 2/11/13, for particulars.

My comment at the time was that coupling a legitimate transaction with a phony tax dodge doesn’t legitimatize the tax dodge.

But Mellon’s fifteen lawyers claim that decoupling the legitimate from the illegitimate still means Mellon should get whatever deductions the legitimate part of the deal threw off. IRS says no, so Judge Kroupa is dealing with a Rule 161 reconsideration.

The Mellon 15 agree that the STARS deal was a sham.  And Judge Kroupa found back in February that when you collapse the phony trusts and imaginary sales agreements and credit default swaps, you get a $1.5 billion loan from Barclays to Mellon at one-month LIBOR plus 20 bps.

Barclays, of course, was one of the prime manipulators of LIBOR.

The Mellon 15 say they want a deduction for that interest, because Mellon really borrowed the money and really paid interest at that rate.

Judge Kroupa: “We held in BNY I [the February sham case] that the STARS transaction should be bifurcated into the STARS structure and the loan for purposes of determining whether the economic substance doctrine barred petitioner from claiming the foreign tax credits and the foreign tax expense deductions for the years at issue. Accordingly, we analyzed the economic substance of the STARS structure separately from the loan. We held that the STARS structure lacks economic substance and that petitioner was not entitled to the interest deductions it had effectively taken on the loan because the interest expense was incurred in furtherance of a transaction lacking economic substance.” 2013 T. C. Memo. 255, at p. 6.

Now we all know that Rule 161 isn’t a free chance to rehash old arguments, and Mellon did have a chance to make at least some of the arguments they’re making here. But although reluctant, Judge Kroupa feels the need to discuss the non-phony part of the deal.

The Mellon 15 argue that Mellon actually got the money, it was available for Mellon to lend out, and Mellon actually paid interest. Therefore said interest should be deductible under Section 163(a). In fact, Tax Court has held that a real debt to finance a phony deal gives rise to an interest deduction; but since this case gets appealed to Second Circuit, that won’t fly, as Second Circuit has shot that one down.

However, in this case, say the Mellon 15, the loan proceeds weren’t used to fund the phony deal. IRS says no, you were going for two tax benefits, and the phony one (the UK tax credits) taints the whole deal.

No, says Judge Kroupa: “Petitioner did not use the loan proceeds to finance, secure or carry out the STARS structure. The loan was not necessary for the STARS structure to produce the disallowed foreign tax credits. Rather, the loan proceeds were available for petitioner to use in its banking business throughout the STARS transaction. Accordingly, the loan served a purpose beyond the creation of tax benefits….” 2013 T. C. Memo. 255, at p. 11.

But the interest is inflated, says IRS; Mellon could have borrowed cheaper in the open market.

So what, asks Judge Kroupa: “Respondent also argues that because petitioner could have obtained a loan at a lower cost in the market place, the loan interest deductions must be denied. We disagree. We have held that a grossly mispriced asset or negative cashflow can contribute to the overall picture of an economic sham. Nevertheless, interest accruing on a real loan that is used for economically substantive activity is deductible under section 163(a) even if the borrower is also motivated by favorable tax consequences. Despite being overpriced, the loan proceeds were available for use in petitioner’s banking business. Accordingly, we hold that petitioner is entitled to deduct the interest that accrued on the loan for the years at issue.” 2103 T. C. Memo. 255, at pp. 11-12. (Citations omitted).

Economic substance (a/k/a sham transaction) is all of a piece. “We have held that the economic substance doctrine cannot be applied selectively to certain consequences of a transaction. Instead, we have given effect either to both the cost and income functions of a transaction or to neither when applying the economic substance doctrine.” 2012 T. C. Memo. 255, at p. 15.

So some consequences of the bogus STARS deal are removed from Mellon’s tax return.

A Taishoff “good try” to the Mellon 15. But I’d like to see what Second Circuit does with this, if IRS elects to appeal. No one disputes the loan was made at an above-market rate. While one might bifurcate the loan and the tax dodge to analyze them, I’d argue one cannot divorce them entirely. The loan was an integral part of the dodge; but for the dodge, Mellon would never have made that loan deal with Barclays. I doubt Mellon’s credit was so poor they had to pay above the odds. I’d argue the above-market interest rate was additional compensation to Barclays for facilitating the dodge. If a colorably legitimate transaction is made to facilitate a dodge, even though not to finance it directly, is the colorably legitimate portion of the deal thereby rendered completely legitimate?

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