In November 2001, Bank of New York, a mid-tier U.S. bank, transferred nearly $8 billion of its own assets to a trust in the small, business-friendly state of Delaware through several layers of newly created companies.

A mixture of home mortgages, shares and other securities, the transferred assets made up almost 10 percent of the bank’s total assets at the time. Yet, the transaction was not discussed with BNY’s regulators; nor was it noted in the bank’s financial statements or annual report. It had little practical effect on the lender’s day-to-day operations — the assets continued to be managed and serviced by the same employees in New York.

But it was a critical first step in setting up a complex structure known as STARS — structured trust advantaged repackaged securities — which U.S. tax authorities claim was used by several American banks as an abusive tax shelter that has cost the government more than $1 billion in tax revenue in the past decade.

This week, BNY will square off against the Internal Revenue Service in U.S. Tax Court in New York over STARS and the tax benefits it triggered for the U.S. bank and U.K.-based Barclays, its counterpart in the deal. At issue is whether STARS was set up primarily to generate artificial foreign-tax credits, as the IRS contends; or was a legal way for BNY to obtain financing at rock-bottom rates.

The arguments heard this week will pose a crucial test of the U.S. government’s resolve to rein in sophisticated corporate tax planning that has sapped vast amounts of potential revenue. Tax authorities worldwide, notably in the U.S. and U.K., are under mounting pressure to show that large companies are shouldering their share of the tax burden as part of a broader political debate about fairness and corporate social responsibility.

“We are upping our game in the large business area, particularly as it relates to international tax issues,” Douglas Shulman, the U.S. internal revenue commissioner, said in a speech this month in Washington, D.C.

For the IRS, losing the STARS disputes would be a serious blow to its strategy in high-value cases, tax lawyers said. For the banks, the risk is both financial — $900 million is at stake in the BNY case alone — and to their reputations.

An investigation last year by the Financial Times and ProPublica first detailed how STARS produced tax benefits for U.S. banks beginning in 1999. In all, six banks — BNY (now Bank of New York Mellon), BB&T, Sovereign (now a unit of Santander), Wachovia (now part of Wells Fargo), Washington Mutual and Wells Fargo — participated in STARS deals with Barclays between 1999 and 2006.

Five of those banks are challenging IRS rulings that disallowed foreign tax credits generated in those transactions. WaMu has settled a STARS dispute in bankruptcy court by agreeing to forgo $160 million in claimed tax credits. In total, the IRS says, the STARS deals created $3.4 billion in foreign tax credits.

Now, documents filed in BNY’s case in the past few weeks — the court proceedings begin Monday — provide unprecedented detail about how STARS was crafted at a time when banks and accounting firms were offering deals for multinational corporations to take advantage of loopholes in rules governing foreign tax credits.

At the simplest level, foreign tax credits are designed to prevent U.S. companies from being taxed twice on overseas income by allowing them to claim credit for taxes paid in foreign jurisdictions.

In the BNY case, the IRS claims STARS allowed both Barclays and BNY to claim credits for the same “illusory” foreign tax charges, ultimately reducing the U.S. government’s tax revenue by $18.15 for every $100 of income funneled through the Delaware trust. “The record will establish that STARS was a pricey financing that no prudent banker would undertake but for the tax benefits generated by the meaningless circulation of cash flows,” according to a court filing by the IRS on March 27.

BNY has argued that the deal was a complex but entirely legal, allowing the bank access to low-cost financing from Barclays for its everyday business activities.

Brainchild of Barclays

Like hundreds of other foreign-tax-driven transactions sold to companies in the boom years before the financial crisis of 2008, STARS was developed by Barclays’ famed structured finance group, known as Structured Capital Markets. Roger Jenkins, one of Britain’s best-known dealmakers, and Iain Abrahams, the expert behind most of the bank’s tax arbitrage transactions, led SCM. The idea was for STARS to manufacture tax credits for Barclays and a U.S. corporate taxpayer by circulating U.S. income through an entity taxed in the U.K., the IRS said in its filing.

Because of the differences between U.S. and U.K. accounting rules, STARS would allow Barclays to reimburse a U.S. company for half the tax paid in the U.K. while not reducing the amount of foreign tax credits that could be claimed by either party, the IRS said. Barclays is not a party to the IRS dispute with BNY and has not been accused of wrongdoing by U.S. authorities.

According to the IRS, blue-chip U.S. companies including Microsoft and insurers AIG and Prudential Life passed on early versions of STARS for unspecified reasons. But the IRS said BNY, which bought the deal in 2001, had grown “addicted” to tax-driven transactions, which provided it with an important source of revenue.

Before buying STARS, the IRS says, BNY had entered into more than 100 “lease-back” transactions, known as Lilos and Silos, that produced tax advantages. Shortly after participating in STARS, BNY also purchased from Barclays another foreign-tax-credit structure, nicknamed Toga, that involved high-grade debt securities, the IRS said.

“Barclays understood that BNY was highly receptive to a wide range of tax-based ideas, and had targeted BNY for an SCM ‘tax product’ after discussions with BNY senior executives,” the IRS said in its court filing.

The IRS also described KPMG as a pivotal player. The accounting firm provided a U.S. tax opinion blessing the structure for Barclays and sold STARS to BNY for a fee of $6 million, according to the IRS filing.

David Brockway, then of KPMG, was engaged to provide the firm’s opinion on STARS, and is expected to testify at trial, according to the IRS. Brockway, a leading U.S. tax lawyer, left KPMG in April 2005 amid scrutiny of the firm’s previous sales of potentially abusive tax shelters.

The IRS also has named lawyer Raymond Ruble, formerly a partner at Sidley Austin in Washington, D.C., as a key adviser on the structure. Ruble was convicted of multiple counts of income-tax evasion in a separate tax-shelter case involving wealthy taxpayers in 2009. He is in a federal prison in Lewisburg, Pa.

The IRS, Barclays, BNY, KPMG and Sidley Austin declined to comment on the case. Jenkins, now a partner at the Brazilian investment bank BTG Pactual; Abrahams, still a senior executive at Barclays in London; and Brockway, now a Washington-based partner at the law firm Bingham McCutchen LLP, also declined to comment.

$900 Million Disputed

Both sides acknowledge that BNY’s STARS deal was executed through highly choreographed steps. First, BNY transferred about $7.9 billion of income-producing assets to the Delaware trust through layers of newly created subsidiaries. Barclays, as the counterpart, acquired shares in the trust, giving it a right to nearly all the income generated by the assets. In return, Barclays loaned $1.5 billion to BNY, also via the trust.

Barclays and BNY then executed a repurchase agreement, or “repo,” under which BNY agreed to buy back the shares in the Delaware trust five years later, in November 2006. BNY appointed a U.K. company as trustee of the Delaware trust, making the income it produced subject to U.K. tax.

At the outset of the deal, the trust’s pool of assets were expected to generate about $460 million of income a year — of which, at a tax rate of 22 percent, $100 million would be paid to U.K. tax authorities. When the trust income failed to reach $460 million, as expected, BNY injected extra assets, essentially to boost the income stream.

At the heart of the structure are differences between how it is treated under U.S. and U.K. tax law. Under U.K. rules, Barclays was allowed to take a deduction against its other taxable income in the U.K. on the condition that it immediately reinvested the income produced by the assets in the trust. But it was able to simultaneously take a credit for the tax paid by the trust.

According to the IRS, those tax benefits were shared with BNY, generating gains for both banks. For every $100 of income circulated through the trust, the U.S. government lost $18.15, which funded BNY’s profit of $7.15, Barclays’ profit of $7.70 and U.K. tax receipts of $3.30, the IRS claims.

But under U.S. tax law, the deal was considered a secured lending arrangement. So, subject to U.S. tax rules, BNY, as owner of the U.K. trust, could also claim a foreign tax credit for the U.K. taxes paid. In 2001 and 2002, BNY claimed nearly $200 million in foreign tax credits from the STARS structure, which the IRS has disallowed. Including interest, the total amount in dispute is about $900 million, according to the bank’s most recent annual report.

“The foreign tax credits that Bank of New York claimed in the U.S. at a 22 percent rate were far more than the actual U.K. tax attributable to STARS,” the IRS said in its filing. “In other words, Bank of New York claimed credits for phantom U.K. tax expense.”

BNY is challenging the IRS’ refusal to allow the credits and says it entered the STARS deal to borrow low-cost funds. Because of the U.K. tax benefits the structure generated for Barclays, BNY claims the British bank was able to provide it with the five-year, $1.5 billion loan at more than three percentage points below the prevailing benchmark lending rate.

“The complication was required by Barclays’ U.K. tax objectives, not by BNY,” the bank said in a court filing March 27. “By lending to [BNY] through the structure that Barclays designed, Barclays could offer a very favorable borrowing rate.”

In the coming weeks, U.S. Tax Court will hear from the bankers, lawyers and accountants involved as well as a raft of experts. A final decision is not expected for at least several months.

With much at stake, BNY and the IRS appear to be digging in for a protracted battle. In its latest filing, BNY accuses the government of using “emotionally laden” arguments to try to deliver a “sweet sound bite.” The IRS says “no rational person” would have participated in STARS if not for the foreign tax credits.

Let the war of words begin.

Vanessa Houlder covers taxation and Megan Murphy investment banking for the Financial Times in London. Senior reporter Jeff Gerth is in Washington, D.C.