In 2009, American International Group (AIG) sued the Internal Revenue Service (IRS) to recover approximately $306 million in denied tax credits.  After negotiating a tortuous litigation process, the dispute has surfaced again in court.  On October 17, 2014, AIG argued before the Second Circuit Court of Appeals that six transactions it entered into from 1993 to 1997 were part of a bona fide spread banking activity and that it should recoup millions in foreign tax credits denied by the IRS relating to the transactions. The IRS, however, asserts that the transactions lacked economic substance, and were only entered into to generate tax benefits.  This case is indeed complex, and raises novel questions about the application of the "economic substance" doctrine.

In each transaction, AIG sold a foreign lender bank preferred shares in a foreign AIG-affiliated Special Purpose Vehicle (SPV), and agreed to repurchase those shares after a term for the same prices paid by the lender bank. The SPV was capitalized primarily from the sale of shares, and it generated income by purchasing investments. The SPV paid taxes on the investment income to the its overseas tax authority, distributing most of the net investment income to the lender bank, who paid no taxes on the the distributed investment income having received it in the form of a tax-exempt dividend. 

Lenders were able to avoid taxes on the distributed income because under the lenders’ home countries' tax rules the transactions were deemed sales, not loans. The lenders were therefore considered owners, and payments as a tax-exempt intracorporate return of capital.  By negotiating a dividend rate far below the SPV’s investment returns, AIG effectively shared the lenders' tax benefit.  AIG's further claimed credits for the SPV's foreign tax payments.  

AIG contends the transactions were part of a bona fide spread banking activity: The SPV borrowed funds from each lender, purchased investments, used the return on the investments to pay the lender a suitable interest, and profited from the difference between the interest and the return on the investments.

The IRS, represented by the Department of Justice (DOJ), on the other hand, asserts that the tax benefits generated that spread profit, and that the tax benefit was the substantial purpose for the transactions. According to the DOJ, AIG and the lender structured the transactions to effectively shift tax liability from the foreign bank to the affiliate SPV. This, the DOJ asserts, allowed the lender to receive its return as a tax-exempt dividend, and enabled AIG to claim foreign tax credits and interest deductions to offset much of the foreign tax paid by the SPV. Those tax savings permitted AIG to negotiate the dividend rate lower than the return on the investments, creating AIG's profitable spread.

If, as the DOJ asserts, the spread was generated entirely by the potential tax benefit, there was no business purpose for the transactions outside the tax benefit. Consequently, the DOJ asserts that the credits claimed for the SPV's foreign tax payments are properly denied because the application of the economic substance doctrine bars the transactions.

AIG, however, claims that the economic substance doctrine does not apply, and that the transactions have economic substance because they were expected to generate a pre-tax profit over the life of the transactions of at least $168.8 million. 

Since 2009, AIG has moved twice for summary judgment. Both of these motions were denied. Consequently, AIG appealed these denials, and now the case is before the Second Circuit.