Stars Wars: Application of the Economic Substance Doctrine to Foreign Tax Credits, and What the Future Holds

The recent, controversial STARS (Structured Trust Advantaged Repackaged Securities) cases provide a backdrop for analyzing how the economic substance doctrine ideally should be applied to foreign tax credit cases. The economic substance doctrine is a judicial doctrine that allows courts to disregard the tax consequences of a transaction that violates the intent of the relevant statute. Its application to foreign tax credits has a long and contentious history, and the STARS cases have given new life to the government’s arguments. After the STARS cases, the circuits are split on the question of how foreign taxes should be treated in computing profit for purposes of the economic substance test. This article argues that foreign taxes should be treated as a cost for such purposes, even in situations in which the taxpayer does not bear the economic burden of the tax. Given the difficulties of applying the economic substance doctrine, the article also discusses possible alternative approaches (either under current law or as changes to the current statutory or regulatory rules). Among such alternatives, the article considers the viability of a subsidy argument in the STARS fact patterns (and in other future cases), although the government chose not to raise this argument in the STARS cases.