* Benefit stems from funding deal with Barclays
* Loan was actually free to BNY Mellon at one time
* IRS calls it a sham tax shelter
By Tim McLaughlin
March 20 (Reuters) - Bank of New York Mellon Corp (BK.N), already under pressure from several state pension fund clients over its forex practices, is preparing to battle the U.S. government over a tax benefit worth roughly a third of what the bank earned last year.
The benefit stems from a $1.5 billion loan from Barclays PLC (BARC.L), which also helped several other U.S. banks generate billions of dollars in tax credits with cheap funding
-- so cheap, in fact, that at one point Barclays actually paid -- so cheap, in fact, that at one point Barclays actually paid BNY Mellon to take Barclays' money. The banks declined to comment.
BNY Mellon's petition against the U.S. Internal Revenue Service, though, provides an inside look at how several U.S. banks capitalized on the loans from Barclays. The U.S. bank has said the tax treatment on the funding was consistent with statutory and judicial authority.
The banks in question used foreign credits to lower their U.S. tax bills by several hundred million dollars each. What the banks call a legal funding strategy, though, lawyers for the IRS call sham tax shelters.
On April 16, BNY Mellon will square off against the IRS in U.S. Tax Court. The stakes are high, as the world's largest custody bank fights to preserve a tax benefit estimated at $900 million. It will also be the first case to go to trial since the IRS accused several U.S. banks of generating artificial foreign tax credits through loans with London-based Barclays.
Experts for the government have pounced on the fact that Barclays sometimes paid the other banks to take its money.
"It not only defies economic theory but common knowledge that banks do not pay borrowers to take their money," said Michael Cragg, chief operating officer of Brattle Group, a global economic consulting firm in Cambridge, Massachusetts.
Cragg's comments appeared in a declaration to a federal court in Minnesota, where Wells Fargo & Co (WFC.N) is fighting to recover $162 million from the U.S. government. Cragg has provided testimony for the government.
KPMG LLP [KPMG.UL], which received millions of dollars in fees in connection with the Barclays financing, declined to comment.
The financing Barclays provided the U.S. banks centered on so-called STARS transactions - or structured trust advantaged repackaged securities. The arrangements are so opaque and complicated that a Harvard-trained federal judge in Minnesota had to call in an outside expert to help him decipher Wells Fargo's arrangement with Barclays.
Each of the banks say the loans from Barclays advanced its core business, according to court papers. Barclays offered them the opportunity to earn greater profits by providing an ultra-cheap source of funding. Any profit would be the difference between their cost of funding and what they earned on the money they invested or put out in loans.
Barclays has not been accused of any wrongdoing in the tax cases. Foreign tax credits are used regularly by U.S. corporations to prevent double taxation on their overseas activities.
But if BNY Mellon had to change its stance on the tax benefit generated from the Barclays loan, that could lead to a big reduction in 2012 profit.
The bank already has warned investors it is "reasonably possible" that its reserve for uncertain tax positions could increase this year by a net amount of up to $850 million, according to U.S. regulatory filings. In 2011 the bank earned about $2.5 billion.
Over the past decade, New York-based BNY Mellon, North Carolina's BB&T Corp (BBT.N), Wells and Sovereign Bank, a unit of Spain's Banco Santander SA (SAN.MC), collectively borrowed more than $5 billion from Barclays. The U.S. banks paid below-market interest rates on the money, which then was subject to a complicated series of transactions.
Barclays gave BNY Mellon, for example, a five-year loan charging an interest rate about 360 basis points below the 3-month London Interbank Offered Rate, or LIBOR, court papers show. This arrangement was similar to what was offered to other banks, according to people familiar with the transactions.
But in 2001 and 2002, LIBOR was so low that the BNY Mellon loan generated negative interest. That meant Barclays paid BNY Mellon $63.3 million instead of charging interest during those two years, according to Tax Court documents.
BNY Mellon said it paid more in total worldwide taxes because it accrued less interest expense, thanks to the Barclays financing. The cheap financing saved BNY Mellon at least $54 million in interest expense each year the Barclays loan was outstanding, BNY Mellon explained in its petition. Less interest expense expanded profit, boosting taxable income overseas.
The bank, for example, said it paid about $200 million in United Kingdom taxes during a two-year stretch at a rate of 22 percent. The bank then claimed foreign tax credits to offset its U.S. tax liability.
But several years later the IRS declared a $1 billion reduction in BNY Mellon's foreign source income, undercutting the bank's argument to offset U.S. tax liability. In 2009, the IRS served the bank and several of its peers with income tax deficiency notices.
Barclays' loans to American banks were structured to give it UK tax benefits. BNY Mellon says UK tax authorities reviewed its transactions with Barclays, according to court records.
The fight with the IRS is the latest legal headache for the bank. Last week the state of North Carolina accused BNY Mellon of making unauthorized investments in Lehman Brothers Holdings Inc. A few days prior, the state of Ohio joined several other states in alleging that the bank overcharged on foreign currency trades.
(Reporting By Tim McLaughlin; Editing by Gerald E. McCormick)
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