Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca13-14-05027/USCOURTS-ca13-14-05027-0/pdf.json

Nature of Suit Code: 210
Nature of Suit: Land Condemnation
Cause of Action: 

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United States Court of Appeals 

for the Federal Circuit ______________________ 

SALEM FINANCIAL, INC., as Successor-in-Interest 

to Branch Investments LLC,

Plaintiff-Appellant

v.

UNITED STATES,

Defendant-Appellee

______________________ 

2014-5027

______________________ 

Appeal from the United States Court of Federal 

Claims in No. 1:10-cv-00192-TCW, Judge Thomas C. 

Wheeler. 

______________________ 

Decided: May 14, 2015

______________________ 

RAJIV MADAN, Skadden, Arps, Slate, Meagher & Flom 

LLP, Washington, DC, argued for plaintiff-appellant. 

Also represented by CHRISTOPHER PAUL BOWERS, ROYCE 

TIDWELL, CHRISTOPHER PATRICK MURPHY, NATHAN P.

WACKER; MATTHEW JAMES DOWD, SCOTT M. MCCALEB, 

Wiley Rein, LLP, Washington, DC. 

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

GILBERT STEVEN ROTHENBERG, RICHARD FARBER. 

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2 SALEM FINANCIAL, INC. v. US

______________________ 

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

BRYSON, Circuit Judge.

Salem Financial, Inc., a subsidiary of Branch Banking 

& Trust Corporation (“BB&T”), challenges a final judgment of the Court of Federal Claims denying BB&T’s 

claim for a refund of taxes, interest, and penalties. We 

affirm in part, reverse in part, and remand for further 

proceedings.

I

A 

BB&T is a financial holding company chartered under 

the laws of North Carolina. In 2002, BB&T entered into a

transaction with Barclays Bank PLC (“Barclays”), which 

is headquartered in the United Kingdom. The transaction, known as the Structured Trust Advantaged Repackaged Securities transaction (“STARS”), was in effect for 

nearly five years, from August 1, 2002, through April 5, 

2007. 

At issue in this case is the U.S. tax treatment of several aspects of BB&T’s involvement in the STARS transaction. When the IRS reviewed BB&T’s tax treatment of 

STARS, it disapproved various tax benefits that BB&T

had claimed based on the transaction. In particular, the 

IRS disallowed foreign tax credits in the amount of 

$498,161,951.00; it disallowed interest deductions in the 

amount of $74,551,947.40; it imposed taxes on certain 

payments from Barclays to BB&T in the amount of 

$84,033,228.20; it disallowed certain transaction cost 

deductions in the amount of $2,630,125.05; and it imposed 

penalties in the amount of $112,766,901.80.

STARS was principally developed by Barclays and 

KPMG LLP, an international accounting firm. The 

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SALEM FINANCIAL, INC. v. US 3

original version of the STARS transaction was marketed 

to non-bank businesses as a means of enhancing investment yield for large, cash-rich corporations located in the 

United States by taking advantage of differences between 

the tax systems in the United States and in the United 

Kingdom. The central component of this early version of 

STARS was a trust having a U.K. trustee and paying U.K. 

taxes. The U.S. participant would then realize an economic benefit by claiming foreign tax credits for the U.K. 

taxes paid by the trust.

In its original form, STARS failed to attract the nonbank entities Barclays had targeted. Those entities 

responded that the yield enhancement was not high 

enough to justify the level of complexity and potential risk

in the transaction. With that feedback, Barclays combined the original STARS structure with a loan component in order to attract banks. Barclays and KPMG then 

promoted the new version of STARS as a “low cost financing” program. The economic benefit to the U.S. participant arising from the foreign tax credits remained the 

same, however, for both the early version and the later 

version of STARS.

In November 2001, Barclays representatives contacted the head of BB&T’s Tax Department regarding the 

prospect of entering into a STARS transaction. The 

parties “discussed in some detail [BB&T’s] appetite to do 

a [foreign tax credit] trade.” Shortly thereafter, BB&T 

met with KPMG and Barclays. At the time of that meeting, KPMG had participated in the implementation of 

STARS transactions between Barclays and two other U.S. 

banks, and BB&T was aware of that fact. It was proposed 

that BB&T would form a U.K. trust with its U.S.-based 

income-generating assets, and Barclays would provide a 

large loan to BB&T. KPMG and Barclays represented 

that BB&T would obtain foreign tax credits against its 

U.S. tax obligations for the U.K. taxes paid by the trust 

and also share in the tax benefits that Barclays would 

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4 SALEM FINANCIAL, INC. v. US

obtain from the U.K. based on its participation in the 

transaction. 

The tax risks of STARS were apparent to BB&T from 

the outset. Those risks included that BB&T might be

denied the full amount of the foreign tax credits on its 

U.S. taxes and that Barclays might be unable to obtain 

the expected tax benefits from the U.K. After a lengthy 

negotiation regarding the allocation of the tax risks, 

BB&T and Barclays reached an agreement and closed the 

transaction on August 1, 2002.

On KPMG’s recommendation, BB&T engaged Sidley, 

Austin, Brown & Wood LLP (“Sidley”) as its tax advisor 

on the STARS transaction. Sidley issued its tax opinion 

on STARS in April 2003. In addition, BB&T tasked 

accounting firm PricewaterhouseCoopers (“PwC”), its 

outside auditor, with evaluating the tax reserve level of 

STARS. 

B 

STARS is a complex transaction consisting of many 

components. The trial court conducted a thorough analysis of the various structures and steps that made up 

STARS. We summarize below the most salient aspects of 

the transaction. 

STARS consisted of a trust component (“the Trust”) 

and a loan component (“the Loan”). Although many 

intermediary entities were created to implement STARS, 

the real parties in interest at all times were BB&T and 

Barclays. BB&T created the Trust, to which it contributed approximately $5.755 billion of U.S.-based incomegenerating assets. The Loan consisted of a payment by 

Barclays of $1.5 billion in cash to the Trust in return for 

subscription to three classes of equity interests in the 

Trust. The Trust, however, remained at all times under 

BB&T’s control, and Barclays was contractually obligated 

to sell its interests in the Trust back to BB&T for $1.5 

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SALEM FINANCIAL, INC. v. US 5

billion when the transaction terminated, so the effect of 

that portion of the transaction was a $1.5 billion Loan 

from Barclays to BB&T. The interest rate on the Loan 

was set at a floating rate of approximately one-month 

LIBOR plus 25 basis points.1

BB&T appointed a U.K. trustee for the Trust. The 

trustee’s U.K. residence subjected the Trust’s income to 

U.K. taxation. Pursuant to the STARS agreements, 

BB&T would receive monthly distributions of the income

generated from the assets held by the Trust. After setting 

aside an amount to pay the U.K. taxes and the management fee, the Trust would remit the remaining funds to 

BB&T. Before doing so, however, the Trust would temporarily place the distributions into the “Barclays Blocked 

Account” at BB&T, which would then immediately return 

those funds to the Trust. That circular movement of the 

Trust distributions generated a substantial tax benefit for 

Barclays by allowing it to claim a “trading loss deduction” 

under U.K. law.

BB&T had the Trust use its funds to pay the U.K. tax

on the Trust’s income. Barclays would then obtain U.K. 

tax deductions and credits for almost all of the U.K. taxes 

paid by the Trust based on Barclays’ nominal equity

interest in the Trust and the circulation of funds through 

the Barclays Blocked Account.

As part of the STARS transaction, Barclays would 

make a monthly payment to BB&T, known as the “Bx 

payment.” The Bx payment was set to be equal to 51 

percent of the U.K. taxes paid by the Trust, which had 

been paid by BB&T and which resulted in the tax benefits 

1 LIBOR, short for “Intercontinental Exchange 

London Interbank Offered Rate,” is a benchmark rate 

that some of the world’s leading banks charge each other 

for short-term loans. 

 

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6 SALEM FINANCIAL, INC. v. US

obtained by Barclays. Each month, BB&T’s interest 

obligation under the Loan and Barclays’ Bx payment 

obligation to BB&T were netted against each other. From 

September 2002 until mid-2005, Barclays, the lender, 

made net monthly payments to BB&T, the borrower,

because the amount of Barclays’ Bx payment obligation 

exceeded the amount of BB&T’s interest obligation. 

The following example illustrates the cash flows in 

and out of the Trust based on $100 of Trust income (ignoring fees). The Trust income was subject to U.K. taxation 

at a 22 percent rate. Therefore, $22 for every $100 of 

Trust income was set aside for payment of the U.K. taxes, 

leaving the Trust with $78 after the U.K. tax payment. 

Because of its nominal equity interest in the Trust, Barclays was also taxed on the Trust income under U.K. law 

at a corporate tax rate of 30 percent, or $30 for every $100 

of Trust income. Barclays, however, was able to claim a 

$22 U.K. tax credit for the $22 of tax paid by the Trust as 

an “imputation credit” that partially offset the higher

corporate tax imposed on the Trust’s distributions. As a 

result, Barclays effectively paid $8 in U.K. tax.

The Trust distributed the after-tax amount of $78 of 

Trust income to the Barclays Blocked Account, from 

which that sum was immediately re-contributed to the 

Trust. Under U.K. law, Barclays was able to treat the recontributed $78 as a “trading loss,” thereby claiming a 

trading loss deduction. At the 30 percent tax rate, that 

deduction was worth $23.40. Barclays’ $8 U.K. tax liability was then completely offset by the $23.40 tax deduction, leaving Barclays with a net tax benefit of $15.40. 

In the example, the Bx payment that Barclays paid to 

BB&T, which was predetermined to be equal to 51 percent of the Trust’s U.K. tax payments, would be approximately $11. Barclays would then deduct the $11 Bx 

payment from its U.K. corporate taxes, which at the 30 

percent tax rate yielded another tax benefit worth $3.30. 

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The net benefit to Barclays, for every $100 in Trust income, was thus $7.70, based on U.K. tax credits and 

deductions (the net tax benefit of $15.40 minus the Bx 

payment of $11, plus the tax benefit of $3.30 attributable 

to the deduction for the Bx payment). 

For its part, BB&T, having paid the $22 U.K. tax on 

the Trust income, would claim a foreign tax credit of $22 

for the entire amount of the Trust’s U.K. taxes. However, 

having received the $11 Bx payment from Barclays, 

BB&T would have a net gain of $11.

The U.K. government effectively collected $3.30 in tax 

for every $100 of Trust income, because the Trust paid 

$22 in U.K. taxes while the U.K. government gave back 

$18.70 in tax benefits to Barclays ($15.40 attributable to 

the trading loss deduction plus $3.30 attributable to the 

Bx payment deduction). Based on the structure of the 

transaction and the amount of the income-generating 

assets in the Trust, BB&T anticipated receiving approximately $44 million per year from the STARS Trust transaction in addition to the revenue generated by the assets 

themselves. 

The capacity of the STARS Trust transaction to generate profits for Barclays and BB&T depended both on 

Barclays’ obtaining the expected tax benefits from the 

U.K. and on BB&T’s obtaining the expected foreign tax 

credits from the U.S. Because of the risks associated with 

obtaining those tax benefits, the parties incorporated

features into the Trust agreement that were designed to 

minimize those risks. The agreement included a “makewhole” provision under which BB&T was obligated to 

reimburse Barclays if the credits generated by the Trust 

failed to match the parties’ expectations. The parties also 

agreed to an indemnity provision, which would be triggered if the Trust paid no tax, either because it was not 

treated as a collective investment scheme under U.K. law 

or because it was not deemed a U.K. resident. BB&T’s 

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8 SALEM FINANCIAL, INC. v. US

indemnity payment to Barclays would be approximately 

one-half of the U.K. tax that the Trust would have paid. 

Finally, both parties were entitled to terminate the 

STARS transaction for any reason, subject to 30 days’ 

notice. 

On March 30, 2007, the IRS published proposed regulations entitled “Regulations on Transactions Designed to 

Artificially Generate Foreign Tax Credits,” 72 Fed. Reg. 

15081 (proposed Mar. 30, 2007). The comments accompanying the proposed regulations noted that “certain U.S. 

taxpayers are engaging in highly structured transactions 

with foreign counterparties in order to generate foreign 

tax credits,” id. at 15081, and explained that the regulations were intended to prohibit the use of “highly engineered transactions where the U.S. taxpayer benefits by 

intentionally subjecting itself to foreign tax,” id. at 15084. 

Under the regulations, “an amount paid to a foreign 

country in connection with such an arrangement is not an 

amount of tax paid,” and as a consequence, “a taxpayer 

would not be eligible to claim a foreign tax credit for such 

a payment.” Id. The notice of the proposed regulation 

stated that the IRS would analyze STARS transactions 

entered into before the effective date of the final regulation under anti-abuse doctrines, including the economic 

substance doctrine. 72 Fed. Reg. 15084 (Mar. 7, 2007). 

Six days after the issuance of the proposed regulations, 

BB&T terminated the STARS transaction pursuant to its 

at-will termination right. 

C 

BB&T filed corporate income tax returns for the tax 

years when it was participating in the STARS transaction. In its returns, BB&T claimed foreign tax credits for 

the Trust’s U.K. tax payments and interest deductions for 

interest it had paid on the Loan. The IRS denied both 

claims and imposed accuracy-related penalties on BB&T. 

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SALEM FINANCIAL, INC. v. US 9

BB&T filed suit in the Court of Federal Claims, seeking a tax refund for the items listed above. Following a 

lengthy trial, the court denied BB&T’s refund request in 

its entirety. Salem Fin., Inc. v. United States, 112 Fed. 

Cl. 543 (2013). Applying the “economic substance” doctrine, the court concluded that the STARS Trust was an 

economic sham lacking both objective economic reality

and a bona fide non-tax business purpose. The court 

therefore held that the tax consequences of the STARS 

transactions had to be disregarded.

The court ruled that the Trust component, “where 

BB&T revenue momentarily is cycled through a U.K. 

trustee to create U.K. taxes and foreign tax credits, and 

then is returned to BB&T, quite clearly is an abusive tax 

avoidance scheme.” 112 Fed. Cl. at 549. The court explained that the Trust “creates a series of instantaneous 

circular cash flows starting and ending with BB&T where 

no economic activity has occurred abroad to justify the 

assessment of a U.K. tax. While inarguably sophisticated 

and creative, the trust purely and simply is a sham transaction accomplishing nothing more than a redirection of 

cash flows that should have gone to the U.S. Treasury,

but instead are shared among BB&T, Barclays, and the 

U.K. Treasury.” Id. 

The court also denied BB&T’s claim for interest deductions on the Loan component of the STARS transaction, based on a finding that the STARS Loan, too, was an 

economic sham. The court reasoned that the Loan was 

not structured to make a profit, but instead was devised 

merely to provide BB&T with a purported business purpose for engaging in the STARS transaction. 112 Fed. Cl. 

at 587.

The court also examined the Trust and the Loan as

part of a single integrated transaction under the economic 

substance doctrine. It concluded that, viewed as an 

integrated transaction, the components of the STARS 

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10 SALEM FINANCIAL, INC. v. US

transaction still lacked economic substance. 112 Fed. Cl. 

at 588-89. 

Finally, the court upheld the accuracy-related penalties assessed by the IRS. The court found that it was 

unreasonable for BB&T to rely on tax opinions from 

KPMG and Sidley, as well as the additional advice from 

PwC. The court thus concluded that the tax opinions 

were ineffective to create a reasonable justification for 

BB&T’s understatements of its tax liability and that the 

imposition of penalties was proper. 112 Fed. Cl. at 589-

94. This appeal ensued.2

II

The characterization of a transaction for tax purposes 

is a question of law that is subject to de novo review, 

while the underlying facts are reviewable for clear error. 

Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 

(1978). For purposes of this appeal, BB&T “accepts the 

trial court’s holding that the Trust Transaction and the 

Loan may be bifurcated.” Appellant’s Br. 18. That is, 

both sides treat the tax consequences of the Trust and 

Loan transactions separately, rather than considering 

2 Besides the Court of Federal Claims in this case, 

the Tax Court in Bank of N.Y. Mellon Corp. v. Comm’r, 

140 T.C. 15, 42 (2013), has held that another STARS 

Trust transaction lacks substance, and a preliminary 

ruling in a district court case involving another STARS 

transaction has rejected the taxpayer’s motion for summary judgment on the business purpose issue. Wells 

Fargo & Co. v. United States, Civil No. 09-cv-2764, 2014 

WL 4070782, at *26-31 (D. Minn. July 22, 2014) (report of 

special master). One district court has ruled that the 

STARS transaction in the case before it did not violate the 

economic substance doctrine. Santander Holdings USA, 

Inc. v. United States, 977 F. Supp. 2d 46 (D. Mass. 2013). 

 

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SALEM FINANCIAL, INC. v. US 11

them as a single integrated transaction. We accordingly 

take the same approach and start with the Trust. 

A 

The characterization of the Bx payment is important 

to the resolution of this case. The government argues 

that the Bx payment is in substance a rebate of the U.K. 

taxes that BB&T paid on behalf of the Trust. BB&T 

contends that under the Internal Revenue Code and the 

Treasury Regulations, the Bx payment must be treated as 

income to BB&T and not as a tax rebate.

Section 901(i) of the Code provides that payments 

made to a foreign country that result in a subsidy or 

rebate to the taxpayer from that country are not creditable taxes. See 26 U.S.C. § 901(i)(1)-(2). Under section 

901(i),

Any income, war profits, or excess profits tax shall 

not be treated as a tax for purposes of this title to 

the extent – (1) the amount of such tax is used (directly or indirectly) by the country imposing such 

tax to provide a subsidy by any means to the taxpayer, a related person (within the meaning of 

section 482), or any party to the transaction or to 

a related transaction, and (2) such subsidy is determined (directly or indirectly) by reference to 

the amount of such tax, or the base used to compute the amount of such tax. 

Id. The pertinent Treasury Regulation provides: 

(i) General rule. An amount of foreign income 

tax is not an amount of income tax paid or accrued 

by a taxpayer to a foreign country to the extent 

that— 

(A) The amount is used, directly or indirectly, by 

the foreign country imposing the tax to provide a 

subsidy by any means (including, but not limited 

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12 SALEM FINANCIAL, INC. v. US

to, a rebate, a refund, a credit, a deduction, a 

payment, a discharge of an obligation, or any other method) to the taxpayer, to a related person 

(within the meaning of section 482), to any party 

to the transaction, or to any party to a related 

transaction; and

(B) The subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of 

the tax.

(ii) Subsidy. The term “subsidy” includes any 

benefit conferred, directly or indirectly, by a foreign country to one of the parties enumerated in 

paragraph (e)(3)(i)(A) of this section. Substance 

and not form shall govern in determining whether 

a subsidy exists. The fact that the U.S. taxpayer 

may derive no demonstrable benefit from the subsidy is irrelevant in determining whether a subsidy exists.

26 C.F.R. § 1.901-2(e)(3). The government concedes that 

BB&T received no tax rebate under the literal terms of 

section 901(i) and the regulation.

Seizing upon the government’s concession, BB&T contends that the inquiry regarding the proper characterization of the Bx payment should stop with the literal terms 

of the Code and regulations. Because the Treasury regulation provides that “substance and not form” determines 

whether a particular payment is a tax rebate, 26 C.F.R. 

§ 1.901-2(e)(3), BB&T argues that the government’s 

concession that BB&T literally complied with section 

901(i) means that BB&T in substance received no tax 

rebate and thus that BB&T received no tax rebate for 

purposes of the economic substance doctrine. 

We disagree that the existence of the “substance-overform” provision in the Treasury regulation precludes 

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SALEM FINANCIAL, INC. v. US 13

analysis under the economic substance doctrine. In Coltec

v. United States, 454 F.3d 1340 (Fed. Cir. 2006), we 

concurred with the Third Circuit and the Eleventh Circuit

that “economic substance is a prerequisite to the application of any Code provision allowing deductions.” Id. at

1356 (citing In re CM Holdings, Inc., 301 F.3d 96, 102 (3d 

Cir. 2002), and Kirchman v. Comm’r, 862 F.2d 1486, 1491 

(11th Cir. 1989)). We analyzed the transaction at issue in 

Coltec under both the statutory “anti-abuse” provision, 

which required an inquiry into the substance of the 

transaction, and “the general economic substance doctrine.” See id. at 1350-52. The economic substance doctrine thus applies even to a transaction that is governed 

by a statute or regulation that itself contains a “substance-over-form” provision. 

While courts may perform a concurrent substance

analysis under both the specific provisions of the Internal 

Revenue Code and the economic substance doctrine, see 

Glass v. Comm’r, 87 T.C. 1087 (1986); DeMartino v. 

Comm’r, 862 F.2d 400 (2d Cir. 1988), the analysis under 

the two is not always the same. For example, BB&T 

offers several reasons why the Bx payment should not be 

deemed a tax rebate under section 901(i). Those reasons 

include that neither the Bx payment nor Barclays’ trading 

loss deduction was tied to any payment of taxes, and that 

Barclays’ credit for the U.K. taxes paid by the Trust was 

an “imputation credit” and thus was not an indirect tax 

rebate. 

Those arguments are highly technical in nature and do 

not address the broader inquiry under the economic 

substance doctrine: whether the Trust transactions lack 

economic reality, whether they lack a bona fide business 

purpose, and whether they are not the kinds of transactions on which Congress intended to confer the benefit of 

the foreign tax credit provision. See Stobie Creek Invs. 

LLC v. United States, 608 F.3d 1366, 1375 (Fed. Cir. 

2010) (to distinguish between a real transaction and a 

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14 SALEM FINANCIAL, INC. v. US

sham transaction under the economic substance doctrine, 

the court examines the economic reality and business 

purpose of the transaction); Coltec, 454 F.3d at 1353 (“The 

economic substance doctrine represents a judicial effort to 

enforce the statutory purpose of the tax code.”). 

BB&T’s argument that the inquiry begins and ends 

with the Code and regulations, if accepted, would largely 

eviscerate the common-law economic substance doctrine. 

Challenges to assertedly abusive tax shelters have frequently involved transactions devised to comply with the 

letter of governing statutes and regulations. As the D.C. 

Circuit observed, “[a] tax system of rather high rates gives 

a multitude of clever individuals in the private sector 

powerful incentives to game the system. Even the smartest drafters of legislation and regulation cannot be expected to anticipate every device.” ASA Investerings 

P’ship v. Comm’r, 201 F.3d 505, 512 (D.C. Cir. 2000). 

Under the traditional economic substance doctrine, the

issue in such cases is whether the transactions are contrivances that are inconsistent with the purposes served 

by the Code provisions and should therefore be disregarded. See, e.g., Gregory v. Helvering, 293 U.S. 465, 469-70 

(1935). Accordingly, the government’s concession that 

BB&T complied with the literal terms of section 901(i)— 

although relevant to our consideration of the objective 

nature of the transaction—does not bar the government

from arguing that the STARS transaction is an economic 

sham.3 

3 BB&T also argues that our precedent precludes 

any further inquiry, beyond section 901(i), into whether 

there was an “in substance” rebate of U.K. taxes in the 

STARS transaction. BB&T relies on a group of cases 

known as the Mexican Railroad Car Cases, which were 

decided before the enactment of section 901(i). In those 

cases, our predecessor court held that, for purposes of 

 

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B 

We now turn to the government’s arguments under 

the economic substance doctrine. “The economic substance doctrine seeks to distinguish between structuring a 

real transaction in a particular way to obtain a tax benefit, which is legitimate, and creating a transaction to 

generate a tax benefit, which is illegitimate.” Stobie 

Creek, 608 F.3d at 1375. “Under this doctrine, we disregard the tax consequences of transactions that comply 

with the literal terms of the tax code, but nonetheless lack 

economic reality.” Id. We have also held that transactions must be disregarded if they are “shaped solely by 

tax-avoidance features,” i.e., if they have no bona fide

business purpose. Id.; see also Coltec, 454 F.3d at 1355.

Ultimately, we have treated the economic substance 

doctrine as a means to “prevent taxpayers from subverting the legislative purpose of the tax code” by engaging in 

fictitious transactions with no economic purpose other 

than the possibility of reaping a tax benefit. Coltec, 454 

F.3d at 1353; see Klamath Strategic Inv. Fund ex rel. St. 

Croix Ventures v. United States, 568 F.3d 537, 543 (5th 

Cir. 2009) (“The economic substance doctrine allows 

courts to enforce the legislative purpose of the [Tax] Code 

by preventing taxpayers from reaping tax benefits from 

determining the amount of creditable foreign taxes, it was 

irrelevant that the foreign government later gave a tax 

rebate to the taxpayer’s foreign counterparty. See Chicago, Burlington & Quincy R.R. Co. v. United States, 455 

F.2d 993, 1022-23 (Ct. Cl. 1972), rev’d on other grounds, 

412 U.S. 401 (1973); see also Bankers Trust N.Y. Corp. v. 

United States, 225 F.3d 1368 (Fed. Cir. 2000). The Mexican Railroad Car Cases and Bankers Trust are inapposite 

here, because neither addresses the applicability of the 

economic substance doctrine. 

 

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16 SALEM FINANCIAL, INC. v. US

transactions lacking in economic reality.”).4 In assessing 

a transaction’s economic substance, “all courts have 

looked to the objective reality of the transaction.” Coltec, 

454 F.3d at 1356. 

We start by examining the “economic reality” of the 

STARS Trust transaction. This inquiry is conducted 

based on objective evidence, rather than on the taxpayer’s 

subjective motivation. Stobie Creek, 608 F.3d at 1375; 

Coltec, 454 F.3d at 1356. The “economic reality” inquiry

asks whether a particular transaction or set of transactions meaningfully altered the taxpayer’s economic position, apart from their tax consequences. That inquiry

often focuses on whether the taxpayer had a “reasonable 

possibility of making a profit from the transaction.” 

Stobie Creek, 608 F.3d at 1376-77. 

BB&T asserts that it realized income from the Trust 

transaction in the form of the monthly Bx payments. The 

IRS initially took the same position and treated the Bx 

4 In 2010, Congress codified the economic substance 

doctrine in 26 U.S.C. § 7701(o). That statute provided

that a transaction shall be treated as having economic 

substance only if “the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position” and “the taxpayer has a 

substantial purpose (apart from Federal income tax 

effects) for entering into such transaction.” Id.

§ 7701(o)(1). The statute was made applicable only to 

transactions initiated after 2010, and it is therefore 

inapplicable to this case; however, our decisions applying 

the economic substance doctrine are consistent with the 

definition Congress adopted in the 2010 legislation, and 

since Congress in that legislation expressed its intention 

to codify the existing judge-made rules, our application of 

those pre-statutory rules is consistent with Congress’s 

endorsement of that approach in 2010. 

 

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SALEM FINANCIAL, INC. v. US 17

payments as part of BB&T’s gross income. The government has since abandoned that position. It now argues 

that the Bx payments should be excluded from BB&T’s 

gross income because they are “in substance” rebates of 

the U.K. tax that was paid by BB&T from the assets

BB&T contributed to the Trust. 

The government treats the Bx payments as tax rebates based on the theory that the payments derived from 

Barclays’ U.K. tax credits, which in turn derived from the 

Trust’s U.K. tax payment. BB&T contends that the Bx 

payments should not be characterized as a tax rebate, 

because they were independent of Barclays’ actual receipt 

of any U.K. tax benefits; Barclays was obligated to make 

the Bx payments regardless of whether it received the 

expected U.K. tax credits. BB&T further argues that the 

Bx payments should be treated as income pursuant to the 

Supreme Court’s decision in Old Colony Trust Co. v. 

Commissioner, 279 U.S. 716 (1929). 

We are not persuaded by BB&T’s first argument, because the Bx payments were not truly independent of 

Barclays’ U.K. tax benefits. It is true that the amount of 

the payments was fixed in the transaction documents and 

was not conditioned on Barclays’ actual receipt of any tax 

benefits. However, the transaction documents provided 

that an indemnity provision would be triggered if Barclays were unable to claim the expected U.K. tax credits, 

either because the Trust paid no tax or because the U.K. 

authority refused to recognize the Trust as a U.K. resident for tax purposes. BB&T would then be obligated to 

indemnify Barclays for approximately one half of the U.K. 

tax that the Trust paid, which was roughly equal to the 

Bx payments. The effect of the indemnity provision was

that if Barclays were unable to recover its expected U.K. 

tax benefits, BB&T would have to return an amount

approximately equal to the Bx payments to Barclays. 

Therefore, the Bx payments were not independent of 

Barclays’ expected U.K. tax benefits at all. BB&T’s 

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18 SALEM FINANCIAL, INC. v. US

ability to benefit economically from the Bx payments 

depended on Barclays’ receipt of its expected tax benefits,

which in turn depended on the Trust’s U.K. tax payments. 

BB&T’s second argument—that the Bx payments 

should be treated as income under Old Colony and its 

progeny—has more force. In Old Colony, a taxpayer’s 

employer agreed to pay all income taxes imposed on 

salary payments to the taxpayer. Old Colony, 279 U.S. at 

721. The Supreme Court held that the income tax payments made by the employer constituted additional 

income to the taxpayer (and therefore were not tax effects), even though those payments were made directly to 

the government. That was because, like the taxpayer’s 

salary, the income taxes were paid “upon a valuable 

consideration, namely, the services rendered by the 

employee and as part of the compensation therefor.” Id.

at 729. “The discharge by a third person of an obligation 

to [the taxpayer] is equivalent to receipt by the person 

taxed.” Id.; see also Diedrich v. Comm’r, 457 U.S. 191, 

197-98 (1982) (“[T]he donor realizes an immediate economic benefit by the donee’s assumption of the donor’s 

legal obligation to pay the gift tax . . . . [T]he economic 

benefit to the donors in the discharge of the gift tax

liability is indistinguishable from the benefit arising from 

discharge of a preexisting obligation.”). 

Other courts have followed Old Colony in assessing a 

taxpayer’s foreign income and tax liability. For example, 

in Compaq Computer Corp. & Subsidiaries v. Commissioner, 277 F.3d 778 (5th Cir. 2001), the Fifth Circuit held 

that the payment of Compaq’s Netherlands tax obligation 

by Compaq’s Netherlands counterparty was income to 

Compaq. The Eighth Circuit followed the same approach 

in IES Industries, Inc. v. United States, 253 F.3d 350 (8th 

Cir. 2001). 

The government does not appear to dispute that, if 

Barclays had paid half of the Trust’s U.K. tax on BB&T’s 

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SALEM FINANCIAL, INC. v. US 19

behalf, that direct tax payment would have constituted 

income to BB&T under Old Colony. The government 

argues, however, that the Old Colony principle is inapplicable in this case because Barclays did not pay BB&T’s 

U.K. tax directly; rather, it reimbursed BB&T for half of 

its U.K. tax expense through the Bx payment. 

That is a distinction without a difference. The Supreme Court held in Old Colony that a third party’s 

assumption of a taxpayer’s tax liability constituted income to the taxpayer because the tax payments had been

made in consideration of services rendered by the taxpayer, and the taxpayer had realized an economic benefit

from the payments. Old Colony, 270 U.S. at 729. That 

principle is not limited to a situation in which a third 

party paid the taxpayer’s taxes directly to the government. Rather, that rationale applies equally if the third 

party instead reimbursed all or part of the taxpayer’s tax 

expenses in exchange for services rendered.

In Reading & Bates Corp. v. United States, 40 Fed. Cl. 

737 (1998), the Court of Federal Claims held that a taxpayer realized income when its Egyptian counterparty 

contractually assumed the taxpayer’s Egyptian tax liability pursuant to a tax indemnification provision in their 

contract. The court recognized that if the contract had 

provided for the counterparty to reimburse the taxpayer’s

Egyptian tax expenses, instead of assuming the taxpayer’s Egyptian tax liability, the change would not have 

affected the characterization of the reimbursements as

income to the taxpayer; it would have affected only the 

date the taxpayer would be deemed to have received the 

income. Id. at 750 n.8.

Like the taxpayer in Old Colony, BB&T realized an 

immediate economic benefit by receiving the Bx payments

from Barclays, which payments effectively repaid half of 

BB&T’s U.K. tax expenses. The payments were made in 

consideration of BB&T’s services rendered under the 

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20 SALEM FINANCIAL, INC. v. US

STARS transaction, including BB&T’s acts of creating the 

STARS Trust and subjecting its U.S.-based assets to U.K. 

taxation. Under the principle of Old Colony, the reimbursements that BB&T received from Barclays must 

therefore be treated as income to BB&T, not tax effects. 

The government nonetheless contends that the specific circumstances of this case justify treating the Bx payments as tax rebates. It argues first that the Bx 

payments are tax rebates because they were designed as 

such. The government points out that, in assessing the 

U.S. tax risk of the STARS transaction, BB&T itself 

referred to the Bx payments as a “Rebate from Barclays.” 

KPMG represented to BB&T that the STARS transaction 

would provide a “rate reduction of 50% of [the Trust’s] UK 

tax.” Barclays likewise stated that the “benefit under 

STARS arises from the ability of both parties [i.e., Barclays and BB&T] to obtain credits for the taxes paid in the 

trust.” 

We do not view this evidence as dispositive for purposes of characterizing the Bx payments. We emphasized 

in Coltec that the economic reality of a transaction must 

be viewed objectively rather than subjectively. See Coltec, 

454 F.3d at 1356. The contracting parties’ own subjective 

view of the transaction may be pertinent to the existence 

of a tax avoidance purpose; however, “all courts have 

looked to the objective reality of the transaction in assessing its economic substance.” Id. Furthermore, the 

government’s evidence at best establishes that the Bx 

payments were designed as a way for Barclays to reimburse BB&T for 50 percent of its U.K. tax expenses. It 

does not explain why, contrary to the Old Colony principle, Barclays’ reimbursement of BB&T’s tax expense must 

be deemed to be a tax effect rather than income. 

The government next argues that the Bx payment 

must be treated as a tax rebate because the payment, 

which was calculated by reference to the Trust’s U.K. 

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SALEM FINANCIAL, INC. v. US 21

taxes, was the product of “tax collusion” between BB&T 

and Barclays; that is, the two entities used the U.K. 

government as a “conduit” to cycle BB&T’s tax payments 

to Barclays through Barclays’ U.K. tax credit, after which 

Barclays returned 51 percent of the taxes to BB&T and 

kept the rest as its fee. The government paints a simple 

picture: that money merely changed hands from BB&T to 

the U.K. government, then to Barclays, and finally back 

to BB&T. The reality, however, is not that simple. 

Barclays was willing to make the payment to BB&T 

because BB&T’s participation in the STARS transaction 

enabled Barclays to realize substantial tax benefits under 

U.K. law. For every $100 of Trust income, Barclays (1) 

paid $30 in corporate income tax; (2) claimed a $22 tax 

credit for taxes already paid by the Trust; (3) claimed a 

trading loss deduction worth $23.40 for the cash it recontributed to the Trust; and (4) claimed a deduction for

the Bx payments that was worth $3.30. Those payments, 

credits, and deductions gave Barclays a net total of $18.70 

in U.K. tax benefits, out of which Barclays paid $11.00 to 

BB&T in the form of the Bx payment. 

It is not at all clear that the Bx payments were the result of “cycling” BB&T’s U.K. tax payments through the 

U.K. government and Barclays. The Bx payments were

paid out of Barclays’ net U.K. tax benefits, which consisted of items clearly linked to BB&T’s U.K. taxes (such as 

the $22 tax credit), as well as items unrelated to BB&T’s 

U.K. tax payments (such as the trading loss deduction

worth $23.40). Thus, the Bx payments could just as well 

be said to have been derived from the portion of Barclays’ 

tax benefits that was independent of BB&T’s U.K. tax 

payments, such as the trading loss deduction, as from 

BB&T’s U.K. tax payments. The government’s own 

expert agreed that the real benefit of STARS was the 

trading loss deduction. It is thus impossible to identify

the exact source of the Bx payments, much less to link the

Bx payments directly to BB&T’s payments of U.K. taxes.

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22 SALEM FINANCIAL, INC. v. US

That the Bx payments were calculated by reference to 

BB&T’s U.K. taxes is insufficient to convince us otherwise. Contracting parties are free to structure their 

transactions based on any payment formula, including 

calculating a payment by reference to a party’s tax liability. See, e.g., Reading, 40 Fed. Cl. at 738-39 (pursuant to 

a drilling contract, a foreign counterparty to the U.S. 

taxpayer agreed to assume the taxpayer’s entire foreign 

tax liability); Doyon Ltd. v. United States, 37 Fed. Cl. 10, 

13 (1996), rev’d on other grounds, 214 F.3d 1309 (Fed. Cir. 

2000) (taxpayer contracted to sell its net operating losses 

and investment tax credits to unrelated corporations that 

sought to shelter some of their income from tax liability). 

Such a tax-based payment formula does not convert 

income into a tax effect. 

We are aware of no authority, and the government 

has provided none, in which courts have treated private 

payments as tax effects rather than income simply because the amount of the payments was calculated based 

on a tax-based formula. The government’s position in this 

regard cannot be squared with prior judicial decisions 

that have held that even when an unrelated party has 

paid 100 percent of a taxpayer’s taxes, that payment must 

still be considered income to the taxpayer. See Old Colony, 279 U.S. at 729; Compaq, 277 F.3d at 784; IES, 253 

F.3d at 354; Reading, 40 Fed. Cl. at 750. 

We therefore conclude that the Bx payments should 

not be characterized as tax effects. Pursuant to Old 

Colony and its progeny, the Bx payments are income to 

BB&T. 

C 

The government next argues that even if the Bx payments are treated as income to BB&T, BB&T realized no 

profit from the Trust transaction absent the foreign tax 

credit because the Bx payments must be offset against the

Trust’s U.K. taxes that were paid by BB&T. The governCase: 14-5027 Document: 56-2 Page: 22 Filed: 05/14/2015
SALEM FINANCIAL, INC. v. US 23

ment argues that, for every $100 of income from the Trust

assets, even if BB&T were credited with $11 income in 

the form of the Bx payment, that $11 would have to be 

offset against BB&T’s $22 U.K. tax expense, which would 

yield a loss of $11. According to the government, the 

Trust transaction produced a net loss and therefore 

lacked economic substance.5 

BB&T contends that the government is wrong in seeking to have the Trust’s U.K. taxes treated as an item of 

expense. BB&T relies on Compaq and IES, two cases 

with almost identical fact patterns, in which the Fifth and 

Eighth Circuits rejected a similar argument. See Compaq, 277 F.3d at 785; IES, 253 F.3d at 354. In Compaq, 

the taxpayer (Compaq) engaged in a foreign transaction 

involving the purchase and immediate resale of certain 

publicly traded securities that represented shares of a 

foreign corporation held in trust by a U.S. bank. The 

settlement dates for the purchase and sale were arranged 

so that the securities were purchased cum dividend and 

sold ex dividend. The purchase and sale transaction thus 

generated a gross dividend for Compaq, which was subject 

to a foreign withholding tax. In addition, because the 

post-dividend sale price of the securities was lower than 

the purchase price (by the amount of the dividend, net of 

the foreign withholding tax), Compaq claimed a capital 

loss on its U.S. taxes for the transaction. It also claimed a 

foreign tax credit for the foreign taxes paid on the gross 

dividend. As a result, the purchase and sale transaction 

5 BB&T contends that we should not address this 

argument because it is raised for the first time on appeal. 

The record shows, however, that the trial court treated 

BB&T’s U.K. taxes as its “out-of-pocket” cost in assessing 

the profit from the STARS transaction. Because the trial 

court addressed this issue, the government’s argument is 

properly before us. 

 

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24 SALEM FINANCIAL, INC. v. US

produced a net gain for Compaq after all taxes were taken 

into consideration. See Compaq, 277 F.3d at 782. 

The Tax Court found that the transaction lacked economic substance because it was in essence a circular 

transaction entailing no risk and no prospect for gain 

other than as a result of the various domestic and foreign 

tax consequences. Compaq Computer Corp. v. Comm’r, 

113 T.C. 214 (1999). In short, it was a classic case of 

cross-border tax arbitrage, and not the kind of transaction 

that, in the Tax Court’s view, Congress intended to benefit through the foreign tax credit statute. Id. at 225 (“The 

foreign tax credit serves to prevent double taxation and to 

facilitate international business transactions. No bona 

fide business is implicated here, and we are not persuaded that Congress intended to encourage or permit a 

transaction such as the [Compaq securities] transaction, 

which is merely a manipulation of the foreign tax credit to 

achieve U.S. tax savings.”).

The Fifth Circuit reversed. The court held that the 

gross dividend, rather than the dividend net of the foreign

tax, should have been used to compute Compaq’s pre-tax 

profit. See Compaq, 277 F.3d at 784. In addition, the 

court faulted the Tax Court for failing to include Compaq’s foreign tax credits in assessing the after-tax profit of 

the entire transaction. See id. at 785. The Fifth Circuit 

reasoned that “[i]f the effects of tax law, domestic or 

foreign, are to be accounted for when they subtract from a 

transaction’s net cash flow, tax law effects should be 

counted when they add to cash flow.” Id. “To be consistent, the analysis should either count all tax law effects

[both foreign tax credits and foreign tax expenses] or not 

count any of them.” Id.; see also IES, 253 F.3d at 354 

(taking the latter approach and treating the gross dividend, not the net dividend, as the economic benefit to the 

taxpayer). 

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SALEM FINANCIAL, INC. v. US 25

The transactions at issue in Compaq and IES involved an almost simultaneous purchase and sale of the 

securities in question; the purchase price was greater 

than the sale price by the amount of the dividend received 

by the taxpayer after foreign taxes on the dividend. The 

transactions therefore did not meaningfully alter the 

taxpayers’ economic position (apart from their tax consequences); they involved essentially no risk (other than the 

risk that the transactions would be disallowed for tax 

purposes); and they offered no opportunity for economic 

gain (except for the tax benefits). Because of the fees paid 

in connection with the transactions, the consequence of 

the transactions, but for the foreign tax credits, would 

have been a certain loss. Thus, the transactions relied for 

their profitability entirely on the availability of a U.S. 

foreign tax credit for the taxes paid to the foreign government. 

The Compaq and IES transactions produced no real 

economic profit. The taxpayer incurred a loss from the 

sale of the securities in the amount of the dividend, net of 

the foreign tax. Any apparent profit from the transactions was the result of offsetting that loss by the amount 

of the dividend, without taking into account the foreign 

taxes paid on the dividend. And 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 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.6 The 

6 Academic commentators, sometimes referring to 

the transactions at issue in those cases as a form of “foreign tax arbitrage,” have argued that the transactions 

should have been disregarded as lacking in economic 

 

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26 SALEM FINANCIAL, INC. v. US

critical question is not whether the transaction would 

produce a net gain after all tax effects are taken into 

consideration; instead, the pertinent questions are whether the transaction has real economic effects apart from its 

tax effects, whether the transaction was motivated only 

by tax considerations, and whether the transaction is the 

sort that Congress intended to be the beneficiary of the 

foreign tax credit provision. 

Our precedent, like that of several other courts, supports the government’s approach, i.e., to assess a transaction’s economic reality, and in particular its profit 

potential, independent of the expected tax benefits. For 

example, in Rothschild v. United States, 407 F.2d 404 (Ct. 

Cl. 1969), our predecessor court examined the economic 

reality of a transaction by asking whether there was “a 

substance. See Bryan Camp, Form Over Substance in 

Fifth Circuit Tax Cases, 34 Tex. Tech. L. Rev. 733, 752-53 

(2003); Mitchell Kane, Compaq and IES: Putting the Tax 

Back in After-Tax Income, 94 Tax Notes 1215, 1217 (Mar. 

4, 2002); Michael S. Knoll, Compaq Redux: Implicit Taxes 

and the Question of Pre-Tax Profit, 26 Va. Tax Rev. 821, 

840 (2007); Michael J. McIntyre, A Vote in the Compaq

Debate, 94 Tax Notes 1716 (Mar. 25, 2002); Daniel N. 

Shaviro and David A. Weisbach, The Fifth Circuit Gets It 

Wrong in Compaq v. Commissioner, 94 Tax Notes 511 

(Jan. 28, 2002); George K. Yin, The Problem of Corporate 

Tax Shelters: Uncertain Dimensions, Unwise Approaches, 

55 Tax L. Rev. 405, 407-13 (2002). Professors Klein and 

Stark argue that the Compaq transaction was not really 

tax arbitrage, but instead was a form of economic arbitrage. Nonetheless, they agree that the absence of risk in 

the Compaq transaction “may well be an adequate reason 

for ignoring the transaction entirely.” William A. Klein &

Kirk J. Stark, Compaq v. Commissioner—Where is the 

Tax Arbitrage?, 94 Tax Notes 1335, 1338 (Mar. 11, 2002).

 

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SALEM FINANCIAL, INC. v. US 27

possibility [or] an opportunity of profit to the taxpayer 

separate and apart from the tax [benefits].” Id. at 412; see 

also IES, 253 F.3d at 354 (under the objective economic 

substance test, the court “will first consider whether there 

was a reasonable possibility of profit . . . apart from tax 

benefits”); Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 

89, 94 (4th Cir. 1985) (“The second prong of the sham 

inquiry, the economic substance inquiry, requires an 

objective determination of whether a reasonable possibility of profit from the transaction existed apart from tax 

benefits.”). In this case, BB&T incurred a large foreign 

tax expense ($22 for every $100 of Trust income) only to 

obtain a smaller income (the $11 Bx payment for every 

$100 of Trust income). The Trust transaction therefore is 

profitless before taking into account BB&T’s expected 

foreign tax credits. 

With that said, however, we disagree with the government’s contention that a transaction’s lack of potential 

for profit before taking U.S. tax benefits into account 

conclusively establishes that the transaction lacks economic reality. The government argues that a transaction 

lacks economic reality if it fails to realize a post-foreigntax profit, i.e., if the pre-tax profit is less than the foreign 

tax expense. Without foreign tax credits, such a transaction would result in an economic loss. This is in essence 

the “economic profit” test contemplated in I.R.S Notice 98-

5, which was never issued as a regulation and was later 

withdrawn. See I.R.S. Notice 98-5, 1998-1 C.B. 334, 1997 

WL 786882 (1997); I.R.S. Notice 2004-19, 2004-1 C.B. 606, 

2004 WL 292126 (2004). The rationale for the “economic 

profit” test was to disallow credits if the “reasonably 

expected economic profit were determined to be insubstantial compared to the value of the foreign tax credits 

expected to be obtained” as a result of the transaction. 

2004 WL 292126, at *1. 

What is critical is to identify transactions lacking economic reality, i.e., those that do not alter the taxpayer’s 

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28 SALEM FINANCIAL, INC. v. US

economic position in any meaningful way apart from their 

tax consequences, typically entailing no risk and no 

significant possibility of profit other than as a result of 

tax considerations. This is to ensure that tax benefits are 

available only if “there is a genuine multiple-party transaction with economic substance which is compelled or 

encouraged by business or regulatory realities, is imbued 

with tax-independent considerations, and is not shaped 

solely by tax-avoidance features that have meaningless 

labels.” Frank Lyon, at 583-84. Even if there is some 

prospect of profit, that is not enough to give a transaction 

economic substance if the prospect of a non-tax return is

grossly disproportionate to the tax benefits that are 

expected to flow from the transaction. See, e.g., Knetsch v. 

United States, 364 U.S. 361, 365-66 (1960) (the taxpayer’s 

transaction with the insurance company “was a fiction,” 

because for a claimed interest deduction of $233,297.68, 

the taxpayer’s annual borrowing only kept a net cash 

value “at the relative pittance of $1,000”). 

While looking to the potential for economic profit is 

useful, the Supreme Court has cautioned that there is “no 

simple device available to peel away the form of [a] transaction and to reveal its substance.” Frank Lyon, 435 U.S. 

at 576. The government’s economic profit test, if applied 

rigidly, would implicate a wide range of transactions that, 

in the government’s view, have not earned a minimum 

profit to justify a finding of economic reality. Yet commentators have identified transactions that would fail the 

profit test but nonetheless should be honored as legitimate business transactions meriting the allowance of 

foreign tax credits. See Daniel N. Shaviro & David A. 

Weisbach, The Fifth Circuit Gets it Wrong in Compaq v. 

Commissioner, 94 Tax Notes 511, 515 (2002) (“To be sure, 

there are many cases where a foreign transaction without 

a pre-tax profit (net of foreign taxes) is not a sham meriting disallowance.”) (giving an example in which a U.S. 

company borrows at 8 percent to make a genuine investCase: 14-5027 Document: 56-2 Page: 28 Filed: 05/14/2015
SALEM FINANCIAL, INC. v. US 29

ment, over a significant period, in a foreign bond or business opportunity that is expected to earn 10 percent 

before foreign tax and 7 percent after foreign tax); James 

M. Peaslee, Creditable Foreign Taxes and the Economic 

Substance Profit Test, 114 Tax Notes 443, 450 (Jan. 29, 

2007) (“On those facts, the taxpayer would have a powerful argument that allowing the [foreign tax] credits is 

consistent with Congressional intent despite the lack of a 

post-foreign tax profit.”); David P. Hariton, The Compaq

Case, Notice 98-5, and Tax Shelters: The Theory Is All 

Wrong, 94 Tax Notes 501, 502 (Jan. 28, 2002) (under the 

government’s profit test, “any taxpayer who borrowed 

money and invested the proceeds in foreign stock would 

have lost its right to credit any foreign withholding taxes 

it paid, since its interest deductions would invariably 

have exceeded its net dividend income”). 

Transactions involving nascent technologies, for instance, often do not turn a profit in the early years unless 

tax benefits are accounted for. To brand such transactions as a sham simply because they are unprofitable 

before tax benefits are taken into account would be contrary to the clear intent of Congress. See Sacks v. 

Comm’r, 69 F.3d 982, 990-92 (9th Cir. 1995) (upholding 

the taxpayer’s claim for regular investment credit and a 

business energy investment credit, where the taxpayer 

entered into a sale/leaseback transaction for solar water 

heaters, and the IRS deemed the transaction as a sham 

because it was unprofitable before tax benefits were 

accounted for). Indeed, Congress often provides tax 

benefits to encourage socially beneficial activity that 

would not be pursued absent tax advantages. 

Therefore, although inquiring into post-foreign-tax 

profit can be a useful tool for examining the economic 

reality of a foreign transaction, we disagree with the 

government that a transaction that fails the profit test 

must necessarily be deemed a sham. Nonetheless, if a 

taxpayer has incurred a large foreign tax expense that 

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30 SALEM FINANCIAL, INC. v. US

would render the transaction unprofitable absent the 

foreign tax credit, that situation demands careful review 

of the transaction. In particular, it requires an inquiry 

into whether the transaction meaningfully alters the 

taxpayer’s economic position (other than with regard to 

the tax consequences) and whether the transaction has a 

bona fide business purpose. The fact that the transaction 

lacks a post-foreign-tax profit does not by itself end the 

economic substance inquiry.

In this case, the trial court’s finding that the Trust 

transaction lacked economic reality was supported by 

more than just the absence of a prospect for profit. The 

trial court found that the Trust transaction consisted of 

“three principal circular cash flows,” which, apart from 

their intended tax consequences, had no real economic 

effect. 112 Fed. Cl. at 585. Through those circular cash 

flows, BB&T (1) created an entity that it used to make 

monthly distributions to the Trust, which the Trust 

immediately returned to that entity, resulting in subjecting the income to U.K. taxes; (2) caused the Trust to 

deposit a predetermined amount of funds into a blocked 

account and then to withdraw those funds immediately, 

enabling Barclays to claim a U.K. tax loss even though 

the transaction had no net economic effect; and (3) “cycled 

tax through the U.K. taxing authority, then to Barclays, 

and then back to [BB&T].” Id. None of those transactions, the court found, had any economic substance. 

As explained above, we do not accept the trial court’s 

characterization of the Bx payment as simply a rebate of 

the Trust’s U.K. tax payments; we agree with the trial 

court, however, that the Trust transaction was a contrived 

transaction performing no economic or business function 

other than to generate tax benefits. The trial court correctly concluded that the income “from BB&T’s preexisting assets cycled through the STARS Trust was not 

[economic] profit from STARS,” but was akin to the 

“transfers of income-producing assets to controlled entiCase: 14-5027 Document: 56-2 Page: 30 Filed: 05/14/2015
SALEM FINANCIAL, INC. v. US 31

ties that do not imbue an arrangement with substance,” 

because “the transfer has no incremental effect on the 

taxpayer’s activities.” 112 Fed. Cl. at 586 (citing cases). 

As the trial court found, the Trust transaction reflected no 

meaningful economic activity by BB&T: the incremental 

profit potential of the Trust (beyond the income already 

generated by the underlying assets) depended entirely on 

Barclays’ and BB&T’s anticipated tax benefits; it exposed 

BB&T to no economic risk (other than the risk that the 

IRS would challenge the tax treatment of the transaction); and it had no realistic prospect of producing a profit 

(apart from the effect of the foreign tax credits).

Rather than being a genuine business transaction involving economic risk, the STARS Trust transaction was 

simply a money machine. By voluntarily subjecting the 

Trust income to U.K. taxes, BB&T obtained a postforeign-tax-credit “profit” of $11 for every $100 of Trust 

income, free of economic risk. If BB&T had increased by 

ten-fold the value of the assets it placed in the Trust, it 

would have increased by ten-fold its “profit” from the 

transaction, quite apart from the legitimate income 

generated by the assets. In addition, Barclays’ gain from 

the transaction would have increased by the same multiple, as would the U.K.’s receipt of taxes, all at the expense 

of the U.S. Treasury. The artificiality of the transaction 

is shown by its unlimited capacity to generate gains, 

without any additional exposure or commitment of resources. The trial court therefore correctly characterized 

the transaction as lacking economic reality, and it properly found that allowing foreign tax credits for such an 

arrangement would be inconsistent with the purposes of 

the foreign tax credit statute. 

D 

We next turn to the second element of the “economic 

substance” test—whether the STARS Trust transaction 

nonetheless had a bona fide business purpose. The trial 

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32 SALEM FINANCIAL, INC. v. US

court found that the STARS Trust had no non-tax business purpose, and that, instead, its sole function was “to 

self-inflict US-sourced BB&T income in order to reap US 

and UK tax benefits.” That finding is amply supported by 

the evidence.

“Asking whether a transaction has a bona fide business purpose is another way to differentiate between real 

transactions, structured in a particular way to obtain a 

tax benefit (legitimate), and transactions created to 

generate a tax benefit (illegitimate).” Stobie Creek, 608 

F.3d at 1379 (citing Coltec, 454 F.3d at 1357); see also 

Shriver v. Comm’r, 899 F.2d 724, 726 (8th Cir. 1990) 

(“The business purpose inquiry examines whether the 

taxpayer was induced to commit capital for reasons only 

relating to tax considerations or whether a non-tax motive, or legitimate profit motive, was involved.”); WinnDixie Stores, Inc. v. Comm’r, 254 F.3d 1313, 1316 (11th 

Cir. 2001) (“The [sham-transaction] doctrine has few 

bright lines, but it is clear that transactions whose sole 

function is to produce tax deductions are substantive 

shams.”) (internal quotations omitted). 

When BB&T first learned of the STARS transaction, 

it expressed to Barclays its “appetite to do an FTC [foreign tax credit] trade.” During the two parties’ subsequent discussions, Barclays represented to BB&T that 

“[t]he benefit under STARS arises from the ability of both 

parties to obtain credits for the taxes paid in the Trust.” 

KPMG likewise promoted STARS to BB&T as generating 

a benefit “based on the U.K. tax credit,” in which the 

greater the amount of Barclays’ tax credits, the greater 

the benefit to BB&T would be. 

When the STARS transaction was presented to 

BB&T’s board of directors in February 2002, BB&T’s chief 

financial officer described the expected benefit of the 

transaction as “one half of UK tax credit received by 

investor [Barclays] for UK income taxes paid by Trust.” A 

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BB&T witness confirmed at trial that STARS “sounded 

like a good deal” at the time because it allowed BB&T to 

claim a foreign tax credit equal to the entire amount of 

the Trust’s U.K. taxes while BB&T was also receiving “a 

payment from Barclays that they had used the tax credit 

as a basis for calculating.”

BB&T and Barclays finalized the STARS transaction 

in July and August 2002. What emerged from the parties’ 

agreement was a Trust consisting entirely of BB&T’s 

U.S.-based assets, which BB&T voluntarily subjected to 

U.K. taxation. Beyond that, BB&T conducted little activity in the U.K. The monthly Bx payment it received, 

sometimes characterized by the parties as a “[loan] interest adjustment,” bore no relationship to the amount of the 

STARS Loan; instead, the payment was calculated based 

on the Trust’s U.K. tax payments. Aside from income 

generated by the Trust’s assets, all incremental cash 

flows into the transaction were the U.K. tax benefits that 

Barclays claimed under STARS.7

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 BB&T 

and Barclays. See Stobie Creek, 608 F.3d at 1379. Barclays agreed to bear half of BB&T’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). BB&T, 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 onehalf of the U.K. tax” from Barclays. Absent those tax 

7 Both parties agree that the analysis of the transaction should focus on the transaction’s incremental 

income beyond the income already generated by the Trust 

assets. 

 

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34 SALEM FINANCIAL, INC. v. US

advantages, the STARS transaction would never have 

occurred.

BB&T contends that the Trust transaction was motivated by valid, non-tax-related business purposes. Significantly, although BB&T argued in the Court of Federal 

Claims that the purpose of the STARS transaction, including the Trust, was to obtain financing, BB&T does not 

make that argument in this court. Instead, BB&T argues, 

first, that it sought to earn a profit, in the form of the Bx 

payment, and that earning a profit is “a quintessential 

business purpose, universally accepted by the courts.” 

Appellant’s Br. 55. The Bx payment, however, does not 

represent profit from any business activity; it is simply 

the means by which Barclays and BB&T shared the tax 

benefits of the Trust transaction. It therefore is not an 

indication that the Trust transaction had a business 

purpose. To hold that a transaction has a bona fide 

business purpose whenever it has a prospect of producing 

economic benefit for the taxpayer would eliminate the 

“business purpose” test altogether, since the taxpayer 

normally will not engage in a transaction absent the 

prospect that it will result in some monetary gain. 

BB&T next argues that the Trust had a legitimate 

business purpose because it was established to enable 

Barclays to claim certain U.K. tax benefits. BB&T relies 

on Northern Indiana Public Service Co. v. Commissioner, 

115 F.3d 506, 512 (7th Cir. 1997), for the proposition that 

accommodating a counterparty’s tax position is a legitimate business purpose. 

BB&T misconstrues Northern Indiana. In that case, 

it was undisputed that the taxpayer had structured the 

transaction at issue to access the Eurobond market, 

where it could borrow at a lower interest rate, and to 

allow foreign lenders to avoid paying a 30 percent U.S. 

withholding tax. See Northern Indiana, 115 F.3d at 511. 

The Seventh Circuit found that the desire to avoid the 30

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percent withholding tax was not the taxpayer’s sole 

purpose in structuring the transaction, and that the 

taxpayer’s foreign counterparty had “engaged in business 

activity of borrowing and lending money at a profit,” 

which had resulted in “actual, non-tax related” changes in 

the taxpayer’s economic position. Id. at 509, 512. The 

court held that such a transaction should not be disregarded as an economic sham simply because tax avoidance was one of the motives for creating or structuring the 

transaction. See id. at 511, 514. Northern Indiana thus 

does not stand for the proposition that accommodating a 

counterparty’s tax position is always a legitimate business 

purpose, as BB&T asserts. 

The Seventh Circuit in Northern Indiana recognized 

that a transaction that is “unrelated to any economic 

activity” and is created solely to obtain tax benefits should 

be disregarded as a sham. 115 F.3d at 511. The creation 

and operation of the STARS Trust is just such a transaction. The incremental profit potential of the Trust depended entirely on Barclays’ and BB&T’s anticipated tax 

benefits. The risk of the transaction rested on “interpretations of tax laws and regulations of the United States, 

the United Kingdom and the State of North Carolina”; the 

risk was unrelated to market conditions, “the time value 

of money,” or the “attendant risks” associated with the 

transaction. See Bank of N.Y. Mellon Corp. v. Comm’r, 

140 T.C. 15, 42 (2013) (discussing another STARS transaction). Thus, while the transaction before the court in 

Northern Indiana was a “real transaction [that was]

structured in a particular way to obtain a tax benefit,” the 

STARS Trust was created solely to generate tax benefits; 

it therefore lacked a bona fide business purpose.8 Stobie

8 BB&T further argues that saving state taxes with 

the STARS Trust is a legitimate business purpose. BB&T 

avoided North Carolina state tax by shifting the Trust’s 

 

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36 SALEM FINANCIAL, INC. v. US

Creek, 608 F.3d at 1379; see also Northern Indiana, 115 

F.3d at 512 (recognizing that Knetsch and similar cases 

“allow the Commissioner to disregard transactions that 

are designed to manipulate the Tax Code so as to create 

artificial tax deductions”). 

We recognize that most of the “business purpose” cases have dealt with transactions created solely to generate 

U.S. tax benefits. The STARS Trust is unusual in that it 

was structured to generate both U.S. and U.K. tax benefits, which were then allocated between the two participating entities. That fact, however, does not change our 

conclusion regarding the absence of any business purpose 

underlying the Trust transaction. 

Allowing credits for taxes paid to other sovereigns “is 

a privilege and a matter of Congressional grace.” Federated Mut. Implement & Hardware Ins. Co. v. Comm’r, 266 

F.2d 66, 70 (8th Cir. 1959); see also Chrysler Corp. v. 

Comm’r, 436 F.3d 644, 654 (6th Cir. 2006). Thus, the 

ultimate question is “whether what was done, apart from 

the tax motive, was the thing which the statute intended.” 

Gregory v. Helvering, 293 U.S. 465, 469 (1935); Coltec, 454 

F.3d at 1355-56. The enactment of the foreign tax credit

statute “indicates appreciation of the practical exigencies 

which lead to the foreign incorporation of subsidiaries for 

the extension by domestic corporations of their business 

income-producing assets from North Carolina to Delaware. In Coltec, we held that “the transaction to be 

analyzed [under the economic substance doctrine] is the 

one that gave rise to the alleged tax benefit.” Coltec, 454 

F.3d at 1356. At issue in this case is BB&T’s claimed 

foreign tax credit, which did not arise from BB&T’s domestic relocation of assets. Therefore, BB&T’s asserted 

business purpose regarding its state tax savings fails 

because it “focuses on the wrong transaction.” Id. at 1358. 

 

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abroad.” Burnet v. Chicago Portrait Co., 285 U.S. 1, 9 

(1932).

The foreign tax credit system aims to achieve “capital 

export neutrality,” thereby removing a possible disincentive to engage in foreign trades because of the burden of 

double taxation. See 56 Cong. Rec. App. 677 (1918) 

(statement of Rep. Kitchin) (“We would discourage men 

from going out after commerce and business in different 

countries if we maintained this double taxation.”); Richard E. Andersen, Foreign Tax Credits 1-2, 5 (1996); Hart 

v. United States, 585 F.2d 1025, 1029 (Ct. Cl. 1978) (“The 

purpose of allowing the credit was to avoid the inequity of 

double taxation of foreign source income.”). In other 

words, the foreign tax credit was intended to remove the 

effect of foreign taxation from an investor’s decisionmaking process and to facilitate purely economic decisions

regarding business opportunities overseas. See Elisabeth 

A. Owens, The Foreign Tax Credit 3 (1961) (“[T]he result 

of the operation of the [foreign tax] credit is that United 

States corporations . . . with the same amount of income 

bear an equal total tax burden on income whether or not 

they are subjected to foreign income taxation.”); Andersen, supra, at 1-2. An elaborate scheme set up solely to

take advantage of a foreign tax system and involving no 

“economically-based business transactions” is not the type 

of transaction Congress intended to promote with the 

foreign tax credit system. See Northern Indiana, 115 F.3d 

at 512. 

Although BB&T received income in the form of the Bx 

payment, the transaction that generated that income 

involved no genuine business activities, and the transaction that produced the Bx payment would not have been 

engaged in but for the system of taxes imposed by the U.S

and U.K. governments. See Northern Indiana, 115 F.3d 

at 512. Congress could not have intended to allow a 

taxpayer to claim a foreign tax credit, at the expense of 

U.S. tax revenue, for a transaction involving no commerce 

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38 SALEM FINANCIAL, INC. v. US

or bona fide business abroad and having no purpose other 

than to obtain foreign and domestic tax benefits. See

Goldstein v. Comm’r, 364 F.2d 734, 742 (2d Cir. 1966)

(“[T]o allow a deduction for interest paid on funds borrowed for no purposive reason, other than the securing of 

a deduction from income, would frustrate [the legislative] 

purpose . . . [and] would encourage transactions that have 

no economic utility but for the system of taxes imposed by 

Congress.”) (citing Knetsch v. United States, 364 U.S. 361, 

367 (1960)).

We therefore sustain the trial court’s finding that the 

STARS Trust lacked a bona fide business purpose. The 

tax consequences of the STARS Trust accordingly must be 

disregarded.9 See Stobie Creek, 608 F.3d at 1375. 

E 

BB&T further alleges that the trial court committed 

legal error by questioning the U.K. government’s imposition of taxes on the Trust. Specifically, BB&T argues that 

the “act of state” doctrine bars the trial court from reconsidering the U.K.’s imposition and collection of income 

taxes from the Trust, and that such reconsideration 

conflicts with the express allocation of tax jurisdiction in 

the U.S.-U.K. Tax Treaty, 2224 U.N.T.S. 247 (July 24, 

2001).10 We do not read the trial court’s determination of 

9 BB&T also argues that if the Bx payment were to 

be treated as an “in-substance” tax rebate, BB&T should 

be allowed to claim forty-nine percent of the foreign tax 

credits because the Bx payment rebated only $51 of every 

$100 of U.K. taxes paid on the Trust. Because we disagree that the Bx payment should be deemed as a tax 

rebate, we need not address that argument.

10 The act of state doctrine “requires that, in the 

process of deciding, the acts of foreign sovereigns taken 

 

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the economic substance of STARS to depend in any way 

on a repudiation of the U.K.’s authority to impose taxes 

on the Trust. Nor do we base our decision on such a 

determination. We therefore do not find BB&T’s argument as to the Treaty or the act of state doctrine to be 

persuasive. 

III

Aside from the foreign tax credits arising from the 

STARS Trust, BB&T also seeks to recover deductions for 

the interest it paid on the $1.5 billion STARS Loan. The 

trial court disallowed the interest deductions, holding 

that the Loan, like the Trust, lacked economic substance. 

The court based its decision primarily on two grounds. 

First, it emphasized that, putting aside the Bx payment, 

the cost of borrowing for the STARS Loan was “significantly higher than rates on comparable sources of available funds.” 112 Fed. Cl. at 587. The court thus concluded 

that the STARS Loan was not the sort of financing transaction a large commercial bank such as BB&T would 

normally engage in. Second, the court found that the 

Loan had no non-tax business purpose, but “simply was a 

method by which to camouflage Barclays’ rebate of a 

portion of BB&T’s UK payments, through [the Bx] payment.” We reach a different conclusion regarding the 

economic substance of the STARS Loan transaction.

Section 163(a) of the Internal Revenue Code, 26 

U.S.C. § 163(a), permits the deduction of “all interest paid 

or accrued within the taxable year on indebtedness.” The 

statute speaks in broad terms. See Coors v. United States, 

572 F.2d 826, 831 (Ct. Cl. 1978); Goldstein, 364 F.2d at

741. It “does not contain any general requirement that 

interest payments, to be deductible, be ordinary, neceswithin their own jurisdictions shall be deemed valid.” 

Voda v. Cordis Corp., 476 F.3d 887, 904 (Fed. Cir. 2007).

 

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40 SALEM FINANCIAL, INC. v. US

sary, reasonable or for a business purpose.” Coors, 572 

F.2d at 831. Nevertheless, “[i]f a transaction underscoring interest payment is considered to be a sham . . . said 

payments are not allowed as interest deductions.” Id. at 

832. 

Our predecessor court noted that cases dealing with

interest deductions generated by loan transactions that 

are challenged as having no prospect for economic gain 

lack uniformity. See Rothschild, 407 F.2d at 408. However, the court explained that the “common denominator 

to be found in those cases denying the interest deduction 

is the conclusion that the loan transaction could not 

appreciably affect the tax payer’s beneficial interest 

except to reduce the taxpayer’s federal income tax.” 

Coors, 572 F.2d at 837; see also Lee v. Comm’r, 155 F.3d 

584, 586 (2d Cir. 1998) (“Interest payments are not deductible if they arise from transactions that can not with 

reason be said to have purpose, substance, or utility apart 

from their anticipated tax consequences.”) (internal 

quotation and citation omitted); see also Knetsch, 364 U.S. 

at 366 (disallowing tax deductions when “it is patent that 

there was nothing of substance to be realized by [the 

taxpayer] from this transaction beyond a tax deduction”).

The government contends that the STARS Loan 

lacked economic reality because, absent the Bx payment, 

BB&T had effectively borrowed the Loan funds at an 

interest rate that was more than 30 basis points higher 

than the rates on comparable sources of funding available 

to BB&T. The government thus asserts that the STARS 

Loan provided no economic benefit to BB&T (other than 

tax benefits) because the proceeds of a loan from another 

source would have yielded the same return at a lower 

cost.

The government relies on Kerman v. Commissioner, 

713 F.3d 849 (6th Cir. 2013), for the proposition that a 

loan transaction is “economically unreasonable” if alterCase: 14-5027 Document: 56-2 Page: 40 Filed: 05/14/2015
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native, lower-interest funding sources were available to 

the taxpayer. We do not interpret Kerman as standing for 

that broad proposition or as being otherwise helpful to the 

government’s argument in this case.

While the Sixth Circuit scrutinized the “absurdly high 

interest rate” of the loan transaction in Kerman (7000 

basis points above market rate), it did not find the transaction to be a sham based solely on the interest rate. 

Rather, the court examined the cost and returns of the 

loan transaction and found that, but for the claimed tax 

benefits, the transaction would have resulted in a sure

loss. See 713 F.3d at 865 (“[R]egardless of what investment Kerman planned to use the loan proceeds for (if 

any), financing with [the loan] transaction did not provide 

him with a reasonable possibility of profit.”). The Kerman

court thus did not hold that a higher-than-market-rate 

interest or the availability of alternative, lower-interest 

funding alone established that the underlying loan transaction was a sham; rather, it engaged in the same inquiry 

that the Rothschild court did, asking whether there was 

something of substance to be realized by the taxpayer 

from the loan transaction, other than tax deductions.

We also do not find the Second Circuit’s decisions in

Lee v. Commissioner and Goldstein v. Commissioner to be 

helpful to the government. In both of those cases, the 

Second Circuit found that interest on the debts in question was not deductible because in each case the underlying transaction giving rise to the debt was “devoid of 

economic substance,” and had “no prospect of realizing 

anything of substance other than tax benefits.” Lee, 155 

F.3d at 586, 587; see also Goldstein, 364 F.2d at 740 

(deduction for interest paid not available for transactions 

“that can not with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences”). 

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42 SALEM FINANCIAL, INC. v. US

In this case, the trial court found that there was no

economic substance to the STARS Loan, because it was 

only a means to “camouflage” Barclays’ rebate of a portion 

of BB&T’s U.K. tax payments. Incorporating a loan 

component into STARS to give the entire transaction the

appearance of “low cost financing” no doubt was one 

intended purpose of the Loan. However, unlike the sort of 

“contrived, ingenious, and complex” loan arrangement 

contemplated in Coors, “whose only ultimate and/or 

realistic purpose was to secure intended tax deduction 

benefits,” Coors, 572 F.2d at 839, the structure of the 

STARS Loan appears straightforward. Moreover, unlike 

the transactions in Lee and Goldstein, there is no evidence 

that BB&T designed the Loan solely to claim the interest 

deductions. Despite the Loan’s higher-than-market 

interest rate, it has not been shown that the transaction 

would result in an economic loss “regardless of what 

investment [BB&T] planned to use the loan proceeds for.” 

See Kerman, 713 F.3d at 865.

While it may be true that the Loan operated partly to 

camouflage the Bx payment, it also resulted in a substantive change in BB&T’s economic position. As a result of 

the Loan transaction, BB&T obtained unrestricted access 

to $1.5 billion in loan proceeds. An impact of that sort 

cannot be said to have resulted in no change in the economic benefits enjoyed by the taxpayer. See Coltec, 454 

F.3d at 1355 (“[T]ransactions, which do not vary control or 

change the flow of economic benefits, are to be dismissed 

from consideration.”); Kerman, 713 F.3d at 865 (noting 

that the taxpayer did not have unfettered access to all the 

loan proceeds under the sham transaction). 

Obtaining financing of that magnitude, in and of itself, would “appreciably affect” the beneficial interest of a 

commercial bank such as BB&T. See ACM P’ship, 157 

F.3d at 261-62 (allowing deduction of economic losses that 

were “separate and distinct from the $87 million tax loss 

that did not correspond to any actual economic loss”); Lee, 

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155 F.3d at 586 (reciting the “undoubted proposition that 

interest on loans incurred to support an economically 

substantive investment is not disqualified as a deduction 

merely because the borrower is also motivated by favorable tax consequences”); Rice’s Toyota World, 752 F.2d at 

95-96 (“[I]t does not follow that the sham nature of the 

underlying transaction supports the Tax Court’s conclusion that the recourse note debt was not genuine. . . . [A] 

sham transaction may contain elements whose form 

reflects economic substance and whose normal tax consequences may not therefore be disregarded.”); Coors, 572 

F.2d at 835 (“Since plaintiffs received insurance coverage 

of this magnitude during the years in issue, it is hard to 

accept defendant’s repeated assertion that plaintiffs 

during those years received nothing of substance from the 

various policy advances or loans except a purported 

interest deduction.”). 

The evidence shows that after the failure of the original STARS transaction, which lacked a loan component, 

Barclays added a financing vehicle (the Loan) to the 

transaction in order to attract banks. Thus, entirely 

apart from the anticipated tax consequences, the STARS 

Loan had real economic utility to BB&T.

In the Bank of New York Mellon Corp. case, which involved a similar STARS trust and loan transaction, the 

Tax Court in its initial opinion did not separately address 

the question whether the interest on the loan component 

of the transaction was deductible. Bank of N.Y. Mellon 

Corp., 140 T.C. at 15. On reconsideration, however, the 

court held that the interest on the loan was deductible. 

Bank of N.Y. Mellon Corp. v. Comm’r, 106 T.C.M. (CCH) 

367 (2013). The court based its ruling in that case on the 

same factors that are present here: (1) the loan was not 

necessary for the STARS structure to produce the disallowed foreign tax credits; (2) the loan proceeds were not 

used to finance, secure, or carry out the STARS structure; 

and (3) the loan served a purpose beyond the creation of 

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44 SALEM FINANCIAL, INC. v. US

tax benefits. Even though the interest rate on the loan 

was above the market rate, the court held that interest is 

deductible under section 163(a) if it accrues “on a real 

loan that is used for economically substantive activity . . . 

even if the borrower is also motivated by favorable tax 

consequences.” Id. at 370. Even though the loan was 

overpriced, the court held that the interest was deductible 

because “the loan proceeds were available for use in 

petitioner’s banking business.” Id.

We agree with the Tax Court’s analysis of the loan 

component of the STARS transaction. It was therefore 

error for the trial court to conclude that the STARS Loan 

had no economic substance and functioned only to camouflage the Bx payment. As in the Bank of New York Mellon 

Corp. case, the STARS Loan in this case functioned to 

provide financing to BB&T, which is a legitimate business 

purpose. Accordingly, we hold that the Loan portion of 

the transaction satisfies the economic substance test and 

that BB&T is entitled to claim interest deductions for the 

interest it paid on the Loan. 

IV

The final issue on appeal is whether the trial court 

properly upheld the accuracy-related penalties imposed 

on BB&T. Section 6662(a) of the Internal Revenue Code 

provides that “[m]andatory, accuracy-related penalties 

apply to certain underpayments of tax that meet the 

statutory requirements.” 26 U.S.C. § 6662(a); Stobie 

Creek, 608 F.3d at 1381. Section 6664(c) of the Code 

recognizes “a narrow defense” to section 6662 penalties, 

provided that the taxpayer can prove that it (1) had 

reasonable cause for the underpayment and (2) acted in 

good faith. 26 U.S.C. § 6664(c); Stobie Creek, 608 F.3d at 

1381. Whether a taxpayer had reasonable cause is a 

question of fact reviewed for clear error. 608 F.3d at 

1381. The most important factor in determining reasonable cause is “the extent of the taxpayer’s effort to assess 

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SALEM FINANCIAL, INC. v. US 45

the taxpayer’s proper tax liability,” judged in light of the 

taxpayer’s “experience, knowledge, and education.” Id.

BB&T asserts that it had reasonable cause for the

underpayments because it reasonably relied on the favorable tax opinion from Sidley and received additional 

supportive advice from PwC.11 For reliance on such 

advice to be reasonable for purposes of section 6664(c), the 

taxpayer must show (1) that the advice relied on was 

based on “all pertinent facts and circumstances and the 

law as it relates to those facts and circumstances”; (2) 

that the advice was not based on any “unreasonable 

factual or legal assumptions” and did not “unreasonably 

rely on the representations, statements, findings or 

agreements of the taxpayer or any other persons”; and (3) 

that the taxpayer’s reliance on the advice was “objectively 

reasonable.” Stobie Creek, 608 F.3d at 1381. Reliance is 

not reasonable if the advisor has “an inherent conflict of 

interest” about which the taxpayer knew or should have 

known; nor is it reasonable if the taxpayer knew or should 

have known that the transaction was “too good to be 

true.” Id. at 1381-82. 

The trial court found that BB&T’s reliance on Sidley’s 

tax opinion was unreasonable because Sidley had an 

inherent conflict of interest of which BB&T knew or 

should have known. That finding is not clearly erroneous. 

The evidence shows that BB&T had selected Sidley on the 

recommendation of KPMG, the principal marketer of 

STARS. Sidley was the tax advisor in a prior STARS 

transaction, also marketed by KPMG. A BB&T witness 

testified at trial that both KPMG and Sidley, BB&T’s two

principal advisors, were involved in “put[ting] [the STARS 

transaction] together.” In a 2001 internal memorandum 

11 On appeal, BB&T no longer argues that it reasonably relied on the advice it received from KPMG, the 

principal marketer of STARS.

 

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46 SALEM FINANCIAL, INC. v. US

regarding Sidley’s compensation package, Mr. Raymond 

J. Ruble—BB&T’s initial tax advisor at Sidley—stated 

that “I intend to continue to exploit ties with KPMG . . . in 

connection with the development of structured tax products.” In light of that evidence, the trial court did not 

clearly err in finding that Sidley and KPMG had a significant interest in convincing BB&T to engage in the STARS 

transaction and that their interest in marketing the 

STARS transaction rendered their advice suspect. 

The evidence also supports the conclusion that BB&T 

knew or should have known of Sidley’s conflict of interest. 

Sidley was recommended to BB&T by KPMG, the principal marketer of STARS. At the time of the recommendation, BB&T knew that Sidley had prepared a favorable 

tax opinion for a prior STARS transaction. Despite that 

knowledge, BB&T’s witness stated that BB&T was expecting an independent opinion from Sidley because the 

facts and circumstances surrounding the STARS transaction offered to BB&T were different from the previous 

version of STARS. Yet even before BB&T formally engaged Sidley, Mr. Ruble sent BB&T a redacted copy of a 

tax opinion prepared for another client, which endorsed 

the STARS transaction. That circumstance alone should 

have raised a red flag that Sidley was not a truly “independent” advisor, because it was willing to endorse a 

transaction before it even started exploring the specific 

circumstances of the transaction for the client. The trial 

court reasonably concluded from that evidence that Sidley 

had an inherent conflict of interest about which BB&T 

knew or should have known. The trial court therefore did 

not clearly err in finding that BB&T’s reliance on Sidley’s 

opinion was unreasonable. 

BB&T also relies on PwC’s participation in the transaction to support the reasonableness of its belief in the 

validity of its tax position. The trial court, however, found

that PwC’s participation did not give BB&T a reasonable 

basis for believing that its tax position was sound, beCase: 14-5027 Document: 56-2 Page: 46 Filed: 05/14/2015
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cause PwC provided no tax opinion to BB&T. That finding is not clearly erroneous. BB&T reported only Barclays, KPMG, and Sidley as its tax advisors on the STARS 

transaction. It instructed PwC, its auditing firm, to focus 

solely on the STARS tax reserve issue and not to explore 

whether STARS complied with the Internal Revenue 

Code. PwC also explicitly informed BB&T that it “in no 

way [was] providing an Opinion” regarding STARS. 

Thus, PwC’s advice to BB&T was not a tax opinion that a 

reasonable taxpayer would have relied on in assessing the 

validity of the transaction for tax purposes. 

Moreover, PwC ultimately arrived at a “less than 

should” level of comfort that the IRS would accept the 

STARS transaction. Despite the qualified nature of 

PwC’s advice, BB&T went ahead with the transaction. 

BB&T cannot now claim that PwC’s “less than should” 

advice provided a reasonable basis for engaging in the 

STARS transaction. Therefore, the trial court did not 

clearly err in concluding that PwC’s involvement in the 

STARS transaction did not provide a reasonable cause for 

BB&T’s understatements. 

BB&T’s reliance on its advisors’ opinions was unreasonable for the additional reason that it should have 

known that the STARS transaction was “too good to be 

true.” Stobie Creek, 608 F.3d at 1383. BB&T’s executives 

who had reviewed the STARS transaction were highly 

educated and well-versed in banking and financing transactions. The evidence shows that during the early stages 

of the discussions between BB&T and Barclays, BB&T’s 

executives were extremely skeptical of the tax benefits of 

the STARS transaction in light of the potential downside 

tax risks. The trial court found that, based on its executives’ education and experience, BB&T knew or should 

have known that claiming nearly $500 million in foreign 

tax credits by subjecting income to economically meaningless activities was “too good to be true.” That finding is 

not clearly erroneous. 

Case: 14-5027 Document: 56-2 Page: 47 Filed: 05/14/2015
48 SALEM FINANCIAL, INC. v. US

Finally, BB&T cites the district court opinion in TIFD 

III-E Inc. v. United States, 8 F. Supp. 3d 142 (D. Conn. 

2014), for the proposition that when an area of law is 

uncertain, a taxpayer cannot be penalized for taking a 

position that could have been a reasonable interpretation 

of the law. In TIFD, the taxpayer had initially won the 

case before the district court. The Second Circuit reversed but, as the district characterized the circuit court’s 

opinion, “openly acknowledged that the case was not a 

slamdunk for the government, because the relevant 

statute and regulations are ambiguous and subject to 

multiple interpretations.” TIFD, 8 F. Supp. 3d at 150. 

On remand for an assessment of penalties, the district 

court found that the taxpayer had a “reasonable basis” for 

the tax position that the court itself had initially upheld.

The court in TIFD held that the taxpayer’s position 

was reasonable because the Second Circuit had explicitly 

acknowledged that the relevant statute and regulations 

bearing on the tax issue in that case were ambiguous. We 

do not regard the application of the economic substance 

doctrine to this case to present any ambiguity. Accordingly, we are not persuaded that BB&T’s position regarding 

the appropriate tax treatment of the STARS transaction

was reasonable. In any event, the district court in TIFD

was not construing the “reasonable cause” and “good 

faith” exception of section 6664(c), but instead the “reasonable basis” provision of section 6662(d)(2)(B)(ii) which, 

as the court explained, is more easily satisfied. See 8 F. 

Supp. 3d at 151. 

We conclude that the trial court did not err in imposing accuracy-related penalties on BB&T. The amount of 

the penalties, however, requires reassessment, as we have 

found that BB&T is entitled to claim interest deductions 

for the interest it paid on the STARS Loan. In light of our 

decision regarding the interest deductions, there may be 

other necessary adjustments in the judgment as well, 

which we leave to the trial court on remand.

Case: 14-5027 Document: 56-2 Page: 48 Filed: 05/14/2015
SALEM FINANCIAL, INC. v. US 49

Each party shall bear its own costs for this appeal. 

AFFIRMED IN PART, REVERSED IN PART, 

AND REMANDED

Case: 14-5027 Document: 56-2 Page: 49 Filed: 05/14/2015