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.