STARR INTERNATIONAL COMPANY, INC., v. UNITED STATES OF AMERICA by UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
The District Court of Columbia dealt with the issue whether Starr International Company Inc (hereinafter referred as “Starr” for brevity) is eligible for lower tax rate on dividends it receives from US sources applying the United States and Switzerland bilateral tax treaty and whether its recent relocation to Switzerland was motivated by tax reasons and therefore fails the principal purpose test.
Starr’s History, Corporate Structure, and Previous Relocations
Starr International (hereinafter referred as “Starr” for brevity) was founded in 1943 by Cornelius Vander Starr. It was initially incorporated in the Republic of Panama, with a objective of developing a worldwide network of insurance agencies that generated international business for U.S.-based insurance companies. By 1970, Starr was headquartered in Bermuda, and was operating over 100 offices in 40 countries. That same year, Starr entered into a transformative agreement with American International Reinsurance Company, Inc. (“AIRCO”), another insurance company founded by Vander Starr. In essence, Starr swapped its insurance businesses for stock in AIRCO. At the same time, Starr reorganized. Starr’s voting shareholders created a new class of non-voting common stock, stock, with full residual rights to Starr’s assets (now mostly AIRCO stock), and issued it to a charitable trust, whose ultimate beneficiary was a New York foundation.
The Charitable Trust was set up as a long-term arrangement with multiple goals. Among the goals of the arrangement were the intentions to protect AIG from unwarranted hostile bids for change in control and to permit Starr, as AIG’s largest shareholder, to make incentive compensation grants to AIG employees.
Starr remained in Bermuda till 2004. In 2004, Starr moved to Ireland. In a July 2009 meeting with U.S. Competent Authority officials, Starr, through its counsel represented that Bermuda was simply “too small of a place for a $20 billion charity,” and that “Bermuda has political problems as well as a lack of skilled workers and professionals.” However, as the Government posited out that there is abundant evidence that the move from Bermuda to Ireland was tax- motivated. Ireland taxes stock dividends at a 5 percent to 10 percent rate, compared with 30 percent in Bermuda, and that prompted the move to Dublin.
In 2005, roughly a year after Starr relocated to Ireland, the Starr began planning for yet another move – move to Switzerland. Starr maintains that these two broad motivations for decisions to relocate to Switzerland were a) flexibility for its charity (Starr indicated that Irish law prohibited it from making donations to charities that were not approved as exempt charities by the Irish Revenue Commissioners. Starr’s “related commitments to the Irish authorities,” purportedly placed “severe practical limitations on the amounts that could be distributed to donees outside of Ireland.” Starr also said it wanted to amend the trust deed so that the trustee—and not Starr itself—would have the power to direct the Trust’s investments and distributions, but the deed “could not effectively be amended under Irish law.”) and b) protection of its assets.
But where should Starr move? The decision making process Starr employed in answering that question is summarized in a “decision matrix” created in 2009, which both parties consider favorable evidence. The decision matrix includes eleven rows, one for each combination of jurisdictions considered as possible homes for Starr and its charitable trust; and four columns, one for each criterion analyzed— namely, “Local Tax,” “U.S. Tax,” “Litigation Risk,” and “Charities Regulation.”
Voting shareholders first determined to locate both Starr itself and the charitable trust in the same jurisdiction, as had been the arrangement for the previous 35 years. Keeping the two entities together would ostensibly provide “the strongest level of legal protection” in the event of a legal challenge. That choice narrowed the eleven options to five: Bermuda, the United Kingdom, the Netherlands, Switzerland, and remaining in Ireland.
Of these, after Bermuda, which had no bilateral tax treaty with the United States, Switzerland offered Starr the least favorable U.S. tax situation (with a rating of “Bad”). Switzerland earned that rating because the tax breaks Starr would have received automatically in the United Kingdom, the Netherlands, and Ireland, were available in Switzerland only by application of Article 22(6)’s discretionary exception. However, Starr claims to have chosen Switzerland despite that rating because it was the only jurisdiction with both a “Low” risk of litigation and “Strong” charities regulation. Starr began the “migration” process in July 2006, and both Starr and Starr AG, the company’s new charitable arm, were Swiss residents by December 11, 2006. As had been the case previously, Starr AG owned the corporation’s non-voting common stock, which represented the lion’s share of the company’s economic value. Starr AG, in turn, was owned by a Swiss-resident foundation, and Starr’s residual beneficiary, in the event of dissolution, was the Starr Foundation, based in New York.
Starr’s Request for Treaty Benefits Under Article 22(6)
The bilateral tax treaty between the United States and Switzerland entitles Swiss-resident entities to a reduction in the tax rate applied to dividends they receive from U.S. sources, provided they meet one of a dozen or so objective criteria enumerated in the treaty. If none of the listed requirements are satisfied, the Internal Revenue Service may still authorize a lower rate if it determines that the Swiss entity was not established for a “principal purpose” of obtaining treaty benefits. These rules are designed to limit treaty benefits to applicants that have a sufficiently strong business or geographic connection to Switzerland.
Article 22 of USA Swiss tax treaty deals with Limitation on Benefits (“LOB”) providing anti-treaty- shopping rules making its benefits unavailable to persons engaged in treaty shopping. Article 22(1) to 22(4) of the tax treaty provides various mechanical tests. On satisfaction of these tests, a person would be automatically eligible for the tax treaty benefits. Article 22(5) provides for mutual co-operation between competent authorities of contracting states. Article 22(6) gives discretionary power to the competent authority of the State in which the income arises to give the benefit of tax treaty even if tests laid down under Article 22 are not satisfied. The relevant extract of Article 22(6) is as follows:
6. A person that is not entitled to the benefits of this Convention pursuant to the provisions of the preceding paragraphs may, nevertheless, be granted the benefits of the Convention if the competent authority of the State in which the income arises so determines after consultation with the competent authority of the other Contracting State.
Starr filed a request for treaty benefits under Article 22(6) on December 21, 2007. In the request, Starr conceded that it was not entitled to benefits under any of Article 22’s mechanical tests laid down under Article 22(1) to 22(4). However, it sought discretionary relief under paragraph 6 primarily on the ground that its move to Switzerland was motivated by charitable considerations, not tax concerns.
After 34 months long enquiry by Competent Authority, on October 13, 2010, after further back-and-forth correspondence, the Competent Authority issued a final determination letter denying Starr’s request for treaty benefits. The letter explained that, under the circumstances, the Competent Authority could not “conclude that obtaining treaty benefits was not at least one of the principal purposes for moving Starr’s management, and therefore its residency, to Switzerland.” In support of that conclusion, the letter highlighted the following four considerations:
- Starr’s original incorporation in Panama and its management and control in Bermuda suggest the original corporate structure may have been developed with tax avoidance purposes in mind and/or with a purpose of avoiding the provision of information on Starr’s activities to the Internal Revenue Service;
- Starr’s re-location to Ireland and its movement of management out of Bermuda a relatively short time before the payment of dividends to Starr further suggests that Starr was seeking to avail itself of the treaty between the United States and Ireland to avoid U.S. tax on those contemplated dividends;
- The transitory nature of Starr’s location in Ireland, which may or may not have been intentionally transitory, and its subsequent movement to Switzerland further suggests its intention of organizing in a treaty jurisdiction to avail itself of a reduced rate of withholding on U.S. source dividends;
- Starr is largely controlled by U.S. individuals and such control is not in accord with recent development of U.S. policy on acceptable corporate ownership for Limitation on Benefits purposes.
Appeal before District Court
Starr brought a claim under the Administrative Procedure Act (“APA”) before District Court of Columbia, alleging that the Competent Authority’s denial of treaty benefits to Starr was “arbitrary, capricious, an abuse of discretion, and otherwise not in accordance with law” under the APA, and asking the Court for a judgment holding denial as unlawful and setting aside that denial.
Before the Court, Starr raised arguments related to both as to what is proper Article 22(6) standard and whether it was reasonably applied by the Competent Authority. Regarding the standard, Starr argues that Article 22(6) was meant to provide relief to anyone not engaged in “treaty shopping,” and that treaty shopping always involves a third-country resident—i.e., a resident of a country not party to the relevant tax treaty. Starr argued that it was domiciled in Switzerland and its beneficial and voting ownership was (largely) either Swiss or American, and therefore Starr could not have been a U.S.-Swiss Treaty shopper and therefore should have got relief under the treaty.
Regarding the application of the standard, Starr counters that, even assuming the Article 22(6) standard lacks a third-country-resident requirement, the Competent Authority arbitrarily and capriciously relied on irrelevant facts and ignored material ones in reaching its determination.
The Proper Legal Standard for Awarding Treaty Benefits Under Article 22(6)
Starr’s argued that Article 22, including its discretionary provision, was developed to combat treaty shopping and the Government does not dispute it. Starr cites the Technical Explanation’s discussion of treaty shopping, which describes the concept as “the use, by residents of third States, of legal entities established in a Contracting State with a principal purpose to obtain the benefits of a tax treaty between the United States and the other Contracting State.” Starr argues that treaty shopping is not just a policy evil that Article 22 was designed to foil, but also the legal standard that the Competent Authority is required to apply when implementing Article 22(6). Starr urges that entities must be awarded benefits so long as they are not “treaty shopping.” Starr’s therefore argued that for treaty shopping exists where: (1) “A Third-Country Resident establishes or uses a Treaty Resident to make an investment in the United States,” and (2) “A principal purpose behind the establishment or use of the Treaty Resident is to obtain treaty benefits for the Third-Country Resident.”
The above interpretation is applied by Starr to its own case and it is argued that that “when the relevant transactions were complete, Starr, Starr AG [the charitable entity housing Starr’s economic value], and the Swiss foundation [that owns Starr AG] were all located in Switzerland” Plus, “more than 83% of Starr’s Voting Shareholders were U.S. citizen individuals and the ultimate beneficiary of the Swiss foundation was another U.S. entity, the [New York-based] Starr Foundation.” Accordingly, because “the vast majority of the control and essentially all of the economic value of Starr was held by entities or individuals resident in Switzerland or the United States (i.e., the parties to the U.S.-Swiss Treaty),” the third-country resident prong of Starr’s proposed Article 22(6) standard could not be satisfied.
The Court observed that Technical Explanation begins by noting that a bilateral tax treaty is properly “a vehicle for providing treaty benefits to residents of the two Contracting states.” Further, as per the Technical Explanation, Article 22 “authorizes a tax authority to deny benefits, under substance-over-form principles” to an individual or entity that does not have a genuine connection to the jurisdiction, even when it resides there on paper. As put succinctly by the Technical Explanation, the Article “effectively determines whether an entity has a sufficient nexus to the Contracting State to be treated as a resident for treaty purposes.” An on-paper resident with “a sufficient nexus to the Contracting State” may be called a bona fide resident.
The Court observes that Article 22(6) is a discretionary provision and confers broad discretion on the Competent Authority. And yet, despite the discretionary nature of Article 22(6), Starr would have the Competent Authority and the Court read into the provision a mechanical rule that leaves no room for discretion.
The Court observes that Technical Explanation is clear about the standards that govern Article 22(6) determinations and those standards are concerned not with the existence of third-country residency, but rather with an entity’s motivation for choosing to establish treaty-country residency. At bottom, this “requires a subjective determination of the taxpayer’s intent.” The Court observed that in light of this clear guidance, it would be a strange result indeed if an entity with a “principal purpose” of obtaining treaty benefits was nevertheless entitled to benefits under Article 22(6).
The Court further observed that Starr’s definition of treaty shopping, by contrast, would narrow the concept to such an extent that even some persons who are not bona fide residents of a treaty nation—persons who lack a “sufficient nexus” to either contracting state—would be entitled to benefits. Of course, that is likely Starr’s reason for proposing such a standard, since it largely concedes that it was not a bona fide resident of Switzerland or the United States at the relevant time.
The Competent Authority’s Application of the Article 22(6) Standard
Starr further contended that the Competent Authority’s determination was arbitrary and capricious even assuming that it correctly framed the Article 22(6) standard. At a broad level, the arguments make two points: first, that the Competent Authority overlooked essential information that would have compelled a different result; and second, that the Competent Authority heeded irrelevant or incorrect facts, and thereby drew unreasonable conclusions.
Starr argues that obtaining tax benefits under the Treaty was not one of its principal purposes in relocating to Switzerland as US tax position could not have been improved by relocating to Switzerland. The Court rejected the contention and here the question was not simply why Starr chose Switzerland over Ireland, but rather why Starr chose Switzerland over any other jurisdiction where it might have moved.
Starr argued that the “decision matrix” conclusively demonstrates that obtaining treaty benefits was not of principal concern to the company when it decided to relocate to Switzerland. The Court observed that the decision matrix itself is suspect evidence – It appears to have been created in 2009, years after the move to Switzerland, and in an effort to convince the Competent Authority that seeking treaty benefits was not a principal motive behind Starr’s move. Further, vide decision matrix, Starr’s acknowledgment that “U.S. Tax” was one of four key criteria that the company analyzed in deciding on a jurisdiction shows that it “constituted a principal consideration” in Starr’s calculus. Further the Court observed that, it is unclear how Starr arrived at its list of five finalist jurisdictions, but presumably that narrowing process would have some bearing on whether treaty benefits were a “principal” factor in its ultimate selection. Finally, Switzerland was rated as “Bad” for U.S. taxes on the decision matrix. But it was definitely better in that regard than at least one of the other finalists (Bermuda), and if the company had been afforded discretionary relief—which Starr certainly seems to indicate was expected—then Switzerland would have tied for first place in that category with the other jurisdictions.
For the above reasons, the Court held that neither Starr’s decision matrix, nor its decision to leave Ireland in favour of Switzerland, inevitably leads to the conclusion that treaty benefits were not a “principal” concern for the company when it chose to relocate. Rather, if the matrix is accepted as reliable evidence of Starr’s decision making process, it actually reveals that “U.S. Tax” considerations were a top priority in selecting Starr’s new home. For these reasons, this evidence does not render the Competent Authority’s determination arbitrary and capricious.
In light of the above discussion, the Court held that it sees nothing arbitrary or capricious in the Competent Authority’s finding that “at least one of the principal purposes for moving Starr’s management, and therefore its residency, to Switzerland” was to obtain tax benefits under the U.S.-Swiss Tax Treaty. By applying the correct legal standard to a host of indisputably relevant facts, the Competent Authority satisfied its obligations under the APA to “examine the relevant data and articulate a satisfactory explanation for its action including a rational connection between the facts found and the choice made.”
Article 24(4) of the India USA tax treaty also provides for similar discretionary power to Competent Authority to grant the benefit under the India USA tax treaty despite a person not being entitled to the tax treaty benefit due to the provisions of Article 24(1) to Article 24(3). Therefore, interpretation placed in the above decision would also be relevant in the Indian context.
Further, Article 7(1) of MLI provides for the Principal Purpose Test (PPT) in MLI. It provides that no benefit under the CTA shall be granted if it is reasonable to conclude that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit. Some of the treaties that will be modified by Article 7(1) of MLI are Singapore, Netherlands, Japan, Ireland, Sweden and France and therefore will incorporate PPT test.
The Court in the case of Starr has rejected the argument that the treaty shopping will only be applicable were third country resident tries to take the benefit of tax treaty. The Court therefore gave emphasis on the history of the taxpayer and “its intent” while relocating to Switzerland. The principle of substance over form has been given importance and discretion of the Competent Authority has been upheld.
The Court has observed that the relevant question is why Starr chose Switzerland over any other jurisdiction where it might have moved. This broadens the scope considerably for the revenue authorities to question any inbound/outbound structure. The Indian revenue authorities may also raise similar question in inbound/outbound structure.