Bank of New York Mellon Corp. v. Commissioner of Internal Revenue

These appeals and cross-appeal, heard in tandem, challenge an opinion and order of the United States District Court for the Southern District of New York (Stanton, J.) and a judgment of the United States Tax Court (Kroupa, J.) applying the “eco*107nomic substance doctrine” to transactions involving foreign tax credits. In both cases, the taxpayers claim they are entitled to tax credits associated with foreign transactions that the government disallowed because it contends the transactions lacked economic substance.

In American International Group., Inc. v. United States, in which American International Group (“AIG”) seeks a tax refund of $306.1 million, the district court held that: 1) the economic substance doctrine applies to the foreign tax credit regime; and 2) the pre-tax benefit that AIG gained from its “cross-border” transactions is to be calculated by taking into account foreign taxes. Accordingly, the district court denied AIG’s motion for partial summary judgment. It certified the matter for interlocutory appeal.

In Bank of New York Mellon Corp. v. Commissioner, which involves alleged tax deficiencies of some $215 million, the Tax Court held a three-week bench trial on the economic substance of the Structured Trust Advantaged Repackaged Securities loan product (“STARS”) purchased by Bank of New York Mellon (“BNY”). The Tax Court held: 1) the effect of foreign taxes is to be considered in the pre-tax analysis of economic substance; and 2) STARS lacked economic substance, and thus BNY could not claim foreign tax credits associated with STARS. The Tax Court further held that certain income from STARS was includible in BNY’s taxable income and BNY was not entitled to deduct interest expenses associated with STARS, but reversed both rulings on reconsideration.

We hold that the economic substance doctrine applies to the foreign tax credit regime generally, and that both the district court and Tax Court properly determined the tax implications of the cross-border and STARS transactions. Accordingly, we affirm.

STATEMENT OF THE CASE

A. The Foreign Tax Credit Regime

Various provisions of the Internal Revenue Code (the “Code”) seek “to mitigate the evil of double taxation.” Burnet v. Chi. Portrait Co., 285 U.S. 1, 7, 52 S.Ct. 275, 76 L.Ed. 587 (1932). The Code taxes all income of U.S. taxpayers earned worldwide. 26 U.S.C. § 61(a). Because this can result in double taxation of a U.S. taxpayer’s income earned abroad — by the country in which it was earned as well as the United States — Congress crafted the “foreign tax credit” regime.

First established by the Revenue Act of 1918, the foreign tax credit regime was intended to facilitate business abroad and foreign trade. 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.”). Under the regime, when a U.S. taxpayer pays income tax to another country due to its business activities in that country, the taxpayer can claim a dollar-for-dollar credit against its U.S. tax liability for the foreign taxes paid. 26 U.S.C. §§ 901-909. This “foreign tax credit” then mitigates double taxation by offsetting the taxpayer’s U.S. taxable income and reducing its overall tax bill. The foreign tax credit regime does not, however, require a taxpayer “to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax.” 26 C.F.R. § 1.901-2(e)(5)(i).

As relevant to the instant cases, the Code deems taxes paid by foreign subsidiaries to be paid by their U.S. parent companies. 26 U.S.C. §§ 902, 960. Thus, *108in a given tax year, a U.S. corporation can claim a “foreign tax credit” in the same amount as the foreign taxes paid by its foreign subsidiary, reducing its total U.S. taxable income.

“Entitlement to foreign tax credits[, however,] is predicated on a valid transaction.” 12 Mertens Law of Federal Income Taxation § 45D:62. To be “valid” and not just a “sham,” a transaction must involve more than just tax benefits: it must have independent economic substance. See DeMartino v. Comm’r, 862 F.2d 400, 406 (2d Cir.1988) (“A transaction is a sham if it is fictitious or if it has no business purpose or economic effect other than the creation of tax deductions.”). Accordingly, as we discuss below, a court can hold that a taxpayer is not entitled to certain deductions or other tax benefits where it finds that the underlying transaction lacks “economic substance” beyond its tax benefits.

B. American International Group, Inc. v. United States

1. The Facts

As AIG acknowledges, the facts relevant to this appeal are largely undisputed.1 To the extent that there is dispute, we construe the facts in the light most favorable to the non-moving party, the government:

Between 1993 and 1997, AIG entered into six cross-border transactions with foreign financial institutions through its subsidiary, AIG Financial Products (“AIG-FP”).2 Through these transactions, AIG-FP borrowed funds at economically favorable rates below LIBOR and invested the funds at rates above LIBOR, ostensibly to make a profit.3

Each cross-border transaction operated as follows. First, AIG-FP created and funded a foreign affiliate — a special purpose vehicle (“SPV”) — to hold and invest funds in a foreign country. Next, AIG-FP sold the SPV’s preferred shares to a foreign lender bank and committed to repurchase the preferred shares on a specific future date at the original sale price. The SPV’s capital was thus primarily comprised of the funds the foreign bank paid for the preferred stock, as well as a smaller contribution from AIG. The SPV then used this capital to purchase investments, earning income for which the SPV paid taxes to the relevant foreign authority. The -SPV then paid most of the net proceeds of this investment income to the foreign bank as dividends.

For U.S. tax purposes, AIG claimed that it owned all of the shares of the SPV and thus treated the foreign bank’s funds for the purchase of the preferred shares as a loan. AIG then deducted the dividends paid by the SPV to the foreign banks as interest expense. AIG also claimed foreign tax credits for the full amount of the foreign taxes paid by each SPV on the pre-*109dividend investment income. Accordingly, on its 1997 U.S. tax return, AIG reported total gross income from the cross-border transactions of $128.2 million from which it deducted $71.9 million in interest expenses, for a net taxable income of $56.3 million. Based on the corporate tax rate of 35%, AIG owed $19.7 million in taxes on the cross-border transactions. But AIG also claimed $48.2 million in foreign tax credits for the foreign taxes paid by the SPVs on total income, which it then used to offset U.S. tax not only on its $19.7 million U.S. tax obligation for the cross-border transaction, but also on some $28.5 million in unrelated income.

At the same time, each foreign bank reported to the relevant, foreign revenue authority that it owned the preferred stock as an equity investment in the SPV. As a result, for foreign tax purposes, the SPV was treated as the foreign bank’s corporate subsidiary. , Accordingly, instead of treating the SPVs distribution to the foreign bank as taxable interest on a loan to AIG, the foreign bank claimed the payments as tax-exempt dividends on which it paid little, if any, tax. Instead, the SPV paid tax on the SPV’s income to the relevant foreign authorities. The foreign bank then shared these tax benefits with AIG-FP by accepting a lower dividend rate than it would have otherwise demanded if its investment income were taxable.

This arrangement effectively reduced AIG’s total tax bill. It also allowed the foreign banks to limit their tax liability, inducing them to accept lower return rates from AIG. Thus, AIG effectively converted certain interest expenses it otherwise would have paid to the foreign banks into foreign tax payments for which it claimed foreign tax credits that it could use in turn to offset unrelated income and reduce its total U.S. tax bill.

AIG claims that the cross-border transactions had economic substance because they were expected to generate a pre-tax profit of at least $168.8 million for AIG over the life of the transactions. To reach this number, AIG calculated pre-tax profit by taking the SPV’s investment income arid subtracting only AIG’s operating expenses and obligations to the foreign banks. Thus, in calculating pre-tax profit, AIG ignored: 1) the foreign tax paid by the SPV; 2) the U.S. tax paid by AIG on the SPVs investment .income; and 3) the value of the foreign tax credits claimed by AIG.

2. Proceedings Below

On March 20, 2008, the Internal Revenue Service (the “IRS”) sent AIG a Statutory Notice of Deficiency for its 1997-1999 taxes. For the 1997 taxable year, the notice claimed an additional income tax of $110.2 million, and interest, penalties, or additions to tax of $12.6 million. Among other penalties and assessments, the IRS disallowed the $48.2 million in foreign tax credits AIG claimed in 1997. On July 8, 2008, the IRS assessed the additional amounts, which AIG paid on August 1, 2008. On August 25, 2008, AIG filed a claim for refund for the amounts paid, claiming they were erroneously assessed by the IRS. On February 27, 2009, because the IRS had not rendered a decision on its refund claim, AIG filed a complaint in the district court seeking a refund of $306.1 million in federal income taxes assessed by the IRS and paid by AIG for its 1997 taxable year.

On July 30, 2010, AIG moved for partial summary judgment, arguing that it was entitled, as a matter of law, to foreign tax credits for the income taxes paid to other countries by its subsidiaries. AIG argued that: 1) the economic substance doctrine does not apply to the foreign tax credit *110regime; and 2) even if the doctrine does apply, the relevant transactions had economic substance because they resulted in $168.8 million in pre-tax profit. On March 29, 2011, the district court denied AIG’s motion without prejudice, concluding that the government had demonstrated the need for more discovery. After the close of fact discovery but before the start of expert discovery, AIG renewed its motion for partial summary judgment on August 1, 2012, limited to the six cross-border transactions.

On March 29, 2013, the district court issued an opinion and order denying AIG’s renewed motion for partial summary judgment. The district court held that: 1) the economic substance doctrine applies to the foreign tax credit regime because Congress intended foreign tax credits to facilitate only “purposive” business transactions; and 2) foreign taxes are to be included as a cost in the calculation of pre-tax benefit from the cross-border transactions. Accordingly, the district court denied AIG’s motion for partial summary judgment. Am. Int’l Grp., Inc. v. United States, No. 09 Civ. 1871(LLS), 2013 WL 1286193 (S.D.N.Y. Mar. 29, 2013).

On November 5, 2013, the district court certified its March 29, 2013 opinion and order for interlocutory appeal under 28 U.S.C. § 1292(b). On November 15, 2013, AIG timely filed a petition in this Court for permission to appeal under Federal Rule of Appellate Procedure 5(a)(2). On March 19, 2014, we granted the petition, and this appeal followed.

C. Bank of New York Mellon v. Commissioner

1. The Facts

We accept the facts as found by the Tax Court at trial unless clearly erroneous. See Banker v. Nighswander, Martin & Mitchell, 37 F.3d 866, 870 (2d Cir.1994).

In 2001, Barclays Bank, PLC — a global financial services company headquartered in London, United Kingdom — and KPMG — an audit, tax, and advisory firm— started promoting a loan product they called “Structured Trust Advantaged Repackaged Securities” or “STARS” to U.S. banks. In marketing STARS to U.S. banks, KPMG explained that a U.K. coun-terparty — here Barclays — would offer a “below market loan,” the low cost of which would be achieved through the “sharing” of certain U.K. and U.S. tax benefits generated by the creation of a trust subject to U.K. taxation. BNY entered into STARS transactions with Barclays in November 2001, and the transactions continued until 2006.

We assume familiarity with the Tax ■ Court’s opinion below, which describes the structure of STARS in detail. The basic operation of the STARS transactions can be summarized as follows. First, BNY created a Delaware trust to which it contributed $7.8 billion in income-producing assets. In exchange for this contribution, BNY received nominal shares in the trust (class A and B units). BNY agreed to install a U.K. resident as the trustee, so the trust’s income would be subject to U.K. taxation. BNY then paid tax on the trust to the United Kingdom, and, in exchange, Barclays agreed to pay BNY a monthly amount equal to half of the U.K. taxes BNY expected to pay on the trust’s income-the so-called “tax-spread.”

Next, Barclays purchased shares in the trust (class C and D units) for $1.5 billion, effectively making a loan in that amount to BNY for the duration of STARS through the trust structure. BNY agreed to repay the loan by purchasing Barclay’s trust units for approximately $1.5 billion at the end of five years. The monthly interest *111rate on the loan was equal to one-month LIBOR plus 30 basis points, minus the aforementioned monthly tax-spread. Under this structure, Barclays made total net monthly payments to BNY of $82.6 million over the life of STARS.

Throughout the five-year duration of the STARS transactions, the trust made monthly distributions of income via a circular, multi-step process. First, BNY distributed funds from its income-earning assets to the trust, and the trust set aside 22% of its income to pay U.K. taxes. With most of the remaining income,4 the trust made monthly class C unit distributions to a Barclays account that was “blocked,” meaning Barclays could not access the funds or control the account. Barclays immediately returned these distributions to the trust each month, and the trust then distributed the funds to BNY, beginning the cycle again.

The resulting tax benefits to both BNY and Barclays from STARS can be illustrated by tracing a hypothetical $100 of trust income through the distribution cycle (ignoring fees and the smaller class A, B, and D distributions). See BNY Appellant’s Br. at 14-15; Salem Fin., Inc. v. United States, 786 F.3d 932, 938 (Fed.Cir.2015) (employing similar hypothetical in reviewing STARS transaction). Under U.K. tax law, Barclays — as owner of the class C units — was deemed the owner of almost all of the trust income and taxed at the 30% U.K. corporate tax rate, obligating it to pay $30 in tax for every $100 of trust income ($100 x 30%). Barclays would reduce this tax bill, however, by claiming a credit for the 22% U.K. tax on the trust, which was paid by BNY. Barclays’ tax liability for the trust income was thus only $8 ($30-$22). BNY, in turn, would claim a foreign tax credit in the United States for the full $22 it had paid in U.K. taxes on the trust’s income.

The income distribution scheme compounded the tax benefits to both parties. Each month, for every $100 of trust income, the trust would set aside $22 to pay U.K. taxes, with $78 remaining for distribution. Because the $78 was first transferred to Barclays’ blocked account and then back to the trust, Barclays could treat the re-contributed $78 as a trading loss and claim a trading loss deduction under U.K. tax law. At the 30% corporate tax rate, the deduction translated to a $23.40 reduction in Barclays’ U.K. taxes ($78 x 30%). The deduction more than offset Barclay’s $8 tax bill from the trust, resulting in a net tax benefit to Barclays of $15.40 ($23.40-$8). Finally, Barclays would pay the $11 tax-spread to BNY— half the trust’s U.K. tax bill of $22. Because Barclays would deduct the cost of the tax-spread from its U.K. corporate taxes, it gained an additional $3.30 in tax benefit ($11 x 30%). In the end, this left Barclays with $7.70 in total tax benefit for each $100 of trust income ($15.40 minus the tax-spread payment of $11, plus the tax-spread deduction of $3.30).

BNY also enjoyed a net tax benefit. While it paid $22 in U.K. taxes, it was effectively reimbursed half this amount upon receipt of the $11 tax-spread from Barclays. Neverthless, it claimed the full $22 as a foreign tax credit in the United States, for a total net gain of $11.

Meanwhile the United Kingdom and United States collected little to no tax revenue on STARS. For each $100 of trust income, the United Kingdom only collected $3.30 in net taxes ($22 in tax paid by BNY minus $18.70 ($15.40 + $3.30) in tax benefits to Barclays). The United *112States collected no taxes from STARS. Yet, for the tax years 2001 and 2002, BNY claimed foreign tax credits of $198.9 million and interest expense deductions of $7.6 million that offset its unrelated income and reduced its overall U.S. tax bill for these years.

2. Proceedings Below

On August 14, 2009, the IRS issued a Statutory Notice of Deficiency to BNY of $100.5 million for its 2001 taxes and $115 million for its 2002 taxes, disallowing foreign tax credits and interest expense deductions it had claimed for those years. On November 10, 2009, BNY petitioned the Tax Court for a re-determination of deficiencies. BNY did not contest that the economic substance doctrine applied to STARS but argued that STARS had economic substance, and that therefore it was entitled to the claimed credits and deductions.

The Tax Court held a three-week bench trial, and on February 11, 2013, issued an opinion holding that the STARS transactions were to be disregarded for U.S. tax purposes. Bank of N.Y. Mellon Corp. v. Comm’r, 140 T.C. 15, 2013 WL 499873 (2013). The court bifurcated its analysis of the STARS trust structure and the $1.5 billion loan and found, in relevant part: 1) foreign taxes but neither loan proceeds nor the tax-spread should be considered in the pre-tax analysis of economic substance; 2) the STARS trust transaction lacked economic substance, as BNY had no purpose in entering the transaction except tax avoidance; 3) the tax-spread should be included in BNY’s taxable income rather than considered a component of loan interest, as it served as a device to monetize anticipated foreign tax credits; and 4) all expenses incurred from the STARS transactions, including interest expenses from the $1.5 billion loan, were not deductible.'

On March 12, 2013, BNY moved for reconsideration of the Tax Court’s rulings with respect to the tax-spreád as taxable income and interest expense deductions. On September 23, 2013, the Tax Court issued a supplemental opinion granting BNY’s petition on these issues and held that 1) the tax-spread was not includible in BNY’s income because it was part of the trust transaction that was disregarded for tax purposes for lacking economic substance; and 2) BNY was entitled to interest expense deductions because the $1.5 billion loan, bifurcated from the STARS trust transaction, had independent economic substance.

The Tax Court entered judgment on February 20, 2014. BNY appealed, and the IRS cross-appealed the Tax Court’s interest expense deduction ruling on the $1.5 billion loan.

DISCUSSION

“The general characterization of a transaction for tax purposes is a question of law subject to review.” Frank Lyon Co. v. United States, 435 U.S. 561, 581 n. 16, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978). We thus review the lower court’s characterization of a transaction de novo, and where the lower court has made underlying factual findings, we review those findings for clear error. See Jacobson v. Comm’r, 915 F.2d 832, 837 (2d Cir.1990); Newman v. Comm’r, 902 F.2d 159, 162 (2d Cir.1990).

We review a district court’s denial of a motion (or partial motion) for summary judgment de novo. Doninger v. Niehoff, 642 F.3d 334, 344 (2d Cir.2011). “Summary judgment is proper only when, construing the evidence in the light most favorable to the non-movant, there is no genuine dispute as to any material fact and the movant is entitled to judgment as a *113matter of law.” Id. (internal quotation marks omitted).

We address (a) the applicability of the economic substance doctrine to the foreign tax credit regime generally; (b) the economic substance of the transactions at issue in the instant cases; and (c) the deduc-tibility of the interest expenses BNY paid on the $1.5 billion loan from Barclays.

A, Applicability of the Economic Substance Doctrine to the Foreign Tax Credit Regime

The “economic substance” doctrine is a common law rule that allows courts to question the validity of a transaction and deny taxpayers benefits to which they are technically entitled under the Code if the transaction at issue lacks “economic substance.” See Gregory v. Helvering, 293 U.S. 465, 468-70, 55 S.Ct. 266, 79 L.Ed. 596 (1935). The doctrine applies to “sham” transactions that “can not with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences.” Goldstein v. Comm’r, 364 F.2d 734, 740 (2d Cir.1966).

AIG argues that the economic substance doctrine cannot be applied to disallow foreign tax credits that comply with all statutory and regulatory requirements.5 AIG contends that because the congressional purpose of foreign tax credits — to prevent double taxation — is clear, a court should never be able to question a taxpayer’s use of the credits under the economic substance doctrine. See AIG Appellant’s Br. at 23-30; cf. Estelle Morris Trs. v. Comm’r, 51 T.C. 20, 43, 1968 WL 1526 (1968) (emphasizing need to limit doctrines like economic substance to “situations which they were intended to cover”).

We disagree. First, the Supreme Court has long held that “substance rather than form determines tax consequences.” Raymond v. United States, 355 F.3d 107, 108 (2d Cir.2004) (quoting Cottage Sav. Ass’n v. Comm’r, 499 U.S. 554, 570, 111 S.Ct. 1503, 113 L.Ed.2d 589 (1991) (Blackmun, J., dissenting)) (internal quotation marks omitted); see Comm’r v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945). As we have recognized, the economic substance doctrine stems from the concern that “even if a transaction’s form matches the dictionary definitions of each term used in the statutory definition of the tax provision, it does not follow that Congress meant to cover such a transaction and allow it a tax benefit.” Altria Grp., Inc. v. United States, 658 F.3d 276, 284 (2d Cir.2011) (internal quotation marks omitted).

Second, AIG misconstrues the purpose behind the economic substance doctrine. The economic substance doctrine exists to provide courts a “second look” to ensure that particular uses of tax benefits comply with Congress’s pin-pose in creating that benefit. See Gregory, 293 U.S. at 469, 55 S.Ct. 266 (observing that, to assess economic substance, a court must look to the purpose of the statute to determine “whether what was done ... was the thing which the statute intended”). It is entirely appropriate for a court to ask, therefore, whether a taxpayer’s claim to foreign tax credits is tied to true “business abroad” resulting in actual out-of-pocket tax payments, or whether its claim to a tax credit derives from sham transactions devoid of a business purpose beyond exploiting differences among foreign tax codes. We have repeatedly acknowledged the applicability of the economic substance doctrine to vari*114ous “sham” transactions. See, e.g., Jacobson, 915 F.2d at 837-38; DeMartino v. Comm’r, 862 F.2d 400, 406-07 (2d Cir.1988); Diggs v. Comm’r, 281 F.2d 326, 329-30 (2d Cir.1960). Further, under Gregory, “a taxpayer carries] an unusually heavy burden” in seeking to show that anti-abuse doctrines like economic substance do not apply to the situation at hand. Diggs, 281 F.2d at 330.

Third, we find no support for the contention that foreign tax credits, by their nature, are not reviewable for economic substance. Congress’s intent in creating foreign tax credits was to prevent double taxation of taxpayers conducting business in the United States and abroad. H.R. Rep. 83-1337, at 4103 (1954) (“The provision was originally designed to produce uniformity of tax burden among United States taxpayers, irrespective of whether they were engaged in business in the United States or engaged in business abroad.”). The legislative history thus focuses on taxpayers engaged in foreign business. Nothing in the history suggests that foreign tax credits are entitled to special immunity from scrutiny under the general economic substance doctrine, which allows a court to ask if a transaction really is “business” within the meaning of the Code. As we have emphasized, the foreign tax credit is designed only for the taxpayer who “desires to engage in purposive activity,” not sham transactions built solely around tax arbitrage. See Goldstein, 364 F.2d at 741 (emphasis added).

Fourth, recent amendments to the Code and its regulations — while not applicable to the instant cases, which predate these changes — support our interpretation of Congress’s intent regarding economic substance. In 2010, Congress codified the economic substance doctrine into the Code, recognizing that “[a] strictly rule-based tax system cannot efficiently prescribe the appropriate outcome of every conceivable transaction that might be devised and is, as a result, incapable of preventing all unintended consequences.” H.R. Rep. 111 — 443, pt. 1, at 295 (2010), 2010 U.S.C.C.A.N. 123, 227. This provision codified the two-part economic substance test used in many Circuits, including ours, and affirmed decades of judge-made law from around the country on economic substance. It did not create categorical exceptions to the doctrine, for foreign tax credits or otherwise.

Further, the Treasury Department issued new regulations (proposed in 2007, finalized in 2011) disallowing foreign tax credits associated with STARS and other similarly convoluted transactions designed to take advantage of foreign tax credits. Because the regulations are not retroactive, their preamble addressed the problem of already existing STARS: “For periods prior to the effective date of final regulations, the IRS will continue to utilize all available tools under current law to challenge the U.S. tax results claimed in connection with such arrangements, including ... the economic substance doctrine.... ” Determining the Amount of Taxes Paid for Purposes of Section 901, 72 Fed.Reg. 15,081, 15,084 (Mar. 30, 2007). These amendments reflect both Congress’s recognition of the economic substance doctrine generally and its concern for potential abuse of foreign tax credits.

We thus hold that the economic substance doctrine can, as a general matter, be applied to disallow foreign tax credits.

B. Economic Substance Analysis

We turn to the transactions at issue in AIG and BNY and evaluate them under our Circuit’s test for economic substance.

*1151. Applicable Law

In determining whether a transaction lacks “economic substance,” we consider: 1) whether the taxpáyer had an objectively reasonable expectation of profit, apart from tax benefits, from the transaction; and 2) whether the taxpayer had a subjective non-tax business purpose in entering the transaction. See Gilman v. Comm’r, 933 F.2d 143, 147-48 (2d Cir.1991). In our Circuit the test is not a rigid two-step process with discrete prongs; rather, we employ a “flexible” analysis where both prongs are factors to consider in the overall inquiry into a transaction’s practical economic effects. See id. at 148; Altria Grp., Inc. v. United States, 694 F.Supp.2d 259, 282 (S.D.N.Y.2010), aff'd, 658 F.3d 276; Long Term Capital Holdings v. United States, 330 F.Supp.2d 122, 171 (D.Conn.2004), aff'd, 150 Fed.Appx. 40 (2d Cir.2005) (summary order).6 “[A] finding of either a lack of a business purpose other than tax avoidance or an absence of economic substance beyond the creation of tax benefits can be but is not necessarily sufficient to conclude the transaction a sham.” Long Term Capital Holdings, 330 F.Supp.2d at 171.7

The preliminary step of the economic substance inquiry is to identify the transaction to be analyzed. Even if the transaction at issue is part of a larger series of steps, “[t]he relevant inquiry is whether the transaction that generated the claimed deductions ... had economic substance.” Nicole Rose Corp. v. Comm’r, 320 F.3d 282, 284 (2d Cir.2003); see Long Term Capital Holdings, 330 F.Supp.2d at 183 (holding that a taxpayer “cannot avoid the requirements of economic substance simply by coupling a routine economic transaction generating substantial profits and with no inherent tax benefits to a unique transaction that otherwise has no hope of turning a profit”).

After isolating the relevant transaction, we begin our analysis of economic substance by determining the objective economic substance of the transaction at issue. We then look to the taxpayer’s subjective business purpose in entering the transaction. Finally, we consider both the objective and subjective analysis to make a final determination of economic substance. See Gilman, 933 F.2d at 148.

a. Objective Economic Substance

The focus of the objective inquiry is whether the transaction “offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits.” Gilman, 933 F.2d at 146 (internal quotation *116marks omitted). As relevant here, our Circuit has yet to determine how profit should be calculated when a transaction involves foreign tax credits. The question is whether, for purposes of the economic substance doctrine, foreign taxes should be treated as costs when calculating pre-tax profit. If the answer is yes, then a transaction will be less likely to appear profitable under the objective prong of the economic substance test.

Other Circuits have taken disparate approaches. In Salem Financial, Inc. v. United States, a case involving the same STARS transactions at issue in BNY, the Federal Circuit concluded that foreign taxes are economic costs that are properly deducted in assessing profitability for the purposes of economic substance. There, as with BNY here, the court determined that for every $100 of trust income, the bank incurred $22 of foreign tax expense and only $11 in income from the tax-spread, for an $11 net loss. 786 F.3d at 946-49. The court also excluded foreign tax credits from the profit calculation, observing that “[o]ur 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.” Id. at 948. Because the Federal Circuit included foreign tax costs — but excluded any foreign tax benefits — in its calculation of pre-tax profit, the court concluded that the trust transaction in STARS was “profitless.” Id. at 949.

The Federal Circuit held, however, that this lack of post-foreign-tax profit did not conclusively establish that a transaction lacks objective economic substance. Id. at 950. The Court ultimately held that STARS lacked objective economic substance, based on both the lack of post-foreign-tax profit and on the circular cash flows through the trust whose only purpose was generating tax benefits. Id. at 950-51.8 Indeed, the court recognized that, as a result, the U.S. taxpayer was reimbursed for half the U.K. tax it had paid by a U.K. STARS counterparty who could claim foreign tax benefits that significantly reduced the net revenues realized by the U.K. from STARS. See id. Thus, the scheme was not objectively profitable and there was no real risk of double taxation, the purpose for which U.S. law afforded a foreign tax credit.

In factually different contexts, the Fifth and Eighth Circuits have taken a different approach to assessing objective economic substance, holding that foreign taxes are not economic costs and should not be deducted from pretax profit. Compaq Comput. Corp. & Subsidiaries v. Comm’r, 277 F.3d 778 (5th Cir.2001), rev’g, 113 T.C. 214, 1999 WL 735238 (1999); IES Indus., Inc. v. United States, 253 F.3d 350 (8th Cir.2001), rev’g, No. C97-206, 1999 WL 973538 (N.D.Iowa Sept. 22, 1999). In both cases, taxpayers purchased publicly traded foreign securities known as American Depository Receipts (“ADRs”) at market prices immediately before the securities were to pay out dividends. Because the securities dividends were subject to a 15% foreign tax, they were priced at the market price plus 85% of the expected dividend. The taxpayer/buyer received 85% of the dividend and quickly resold the securities for market price back to the seller, sustaining *117a “loss” because the post-dividend market price of the securities was lower than the original purchase price. The taxpayer then claimed capital loss deductions in the United States, as well as foreign tax credits for the 15% foreign tax paid on the dividend. See , Compaq, 277 F.3d at 779-80; IES, 253 F.3d at 352.

In analyzing the profitability of these transactions, both the Compaq and IES courts declined to consider the foreign taxes paid and foreign tax credits claimed in their economic substance analysis. Rather, the courts calculated profitability based on the gross dividend, before foreign taxes were paid. Compaq, 277 F.3d at 785; IES, 253 F.3d at 353-54. Accordingly, the Eighth Circuit awarded IES summary judgment on its tax refund claim because the ADR transactions did not lack economic substance or a business purpose as a matter of law. 253 F.3d at 356. The Fifth Circuit in Compaq reversed the Tax Court below, holding that it erred in ignoring Compaq’s pre-tax profit on the ADRs. 277 F.3d at 784.

The court in Compaq also faulted the Tax Court below for including foreign taxes paid but not foreign tax credits claimed in its calculation of pre-tax profit. “To be consistent, the analysis should either count all tax law effects or not count any of them. To count them only when they subtract from cash flow is to stack the deck against finding the transaction profitable.” Compaq, 277 F.3d at 785; see also IES, 253 F.3d at 354.

The Tax Court in BNY acknowledged that its holding was inconsistent with Compaq and IES but noted that it was not bound by either decision. Emphasizing that neither the Supreme Court nor our Circuit had yet addressed the issue, the Tax Court