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September 25, 2011 9:30 pm
Judge Patrick Schiltz is an educated man. He earned his degree from Harvard Law School, won a coveted clerkship for US Supreme Court Justice Antonin Scalia, and served as a law professor for more than a decade before joining the bench as a federal judge in Minnesota in 2006.
But when Wells Fargo, a retail banking company, and the Department of Justice squared off in his courtroom last year over the legality of a complicated tax scheme – known by its acronym as Stars – Judge Schiltz quickly realised even he was not equipped to parse the facts.
“I fear I may finally have met my match,” he told the court. “We may need a translator in this case, someone who can help us to understand these complex transactions and understand the complex tax laws to put this into English for us.”
He is not alone. The growth of an arcane, intellectually demanding area of high finance that generated hundreds of millions of dollars for banks and multinational companies during the credit boom is being dissected from Minnesota to Iowa to Washington as the US government pursues what it calls tax avoidance fuelled by the use of artificial foreign tax credits.
The Stars cases have become a crucial battleground in challenges by US tax authorities to billions of dollars of foreign tax credits claimed in the past decade. Stars – short for “structured trust advantaged repackaged securities” – were deals between American banks and Barclays, one of the UK’s premier banks, in London.
At issue is whether the transactions had a legitimate business purpose or were designed specifically to generate improper US tax credits.
Barclays was a key player in creating strategies that worked asymmetries in tax systems. In the Stars deals in question, it realised at least $800m in tax savings from the UK government, benefits it shared with other parties in the deal, according to an analysis of US court and Internal Revenue Service documents by the Financial Times and ProPublica, a non-profit investigative news organisation.
The Stars disputes have produced a vast number of court documents – in bankruptcy, district, tax and claims courts – that offer rarely seen details about the secretive world of structured finance. Revelations about the deals arise amid a much larger political debate about corporate profits, tax fairness and global competition.
As election year 2012 looms, President Barack Obama is facing direct challenges from Republicans about how best to reduce the US corporate tax rate, at 35 per cent, one of the world’s highest – and about why American businesses hold an estimated $1,800bn in profits overseas.
The IRS has been battling six US banks – BB&T, Bank of New York Mellon, Sovereign (now a unit of Banco Santander), Washington Mutual, Wells Fargo and Wachovia (now a Wells Fargo subsidiary) – over tax credits they claimed through Stars. In one instance, the government says Stars permitted BB&T to claim $1 in US tax credits for every 50 cents in tax, “grossly exploiting the tax laws”.
BB&T, based in North Carolina, responded in court that it participated “to maximise profits’’ and not “to avoid or evade’’ taxes.
The US banks all say their deals had economic substance because Barclays provided them with billions in financing at below-market costs. But each lending arrangement involved a series of transactions, including the creation of a trust and subsidiaries that provided significant tax breaks.
The US government, in recent court filings, contends Stars was a highly complex tax shelter transaction used by the American banks to generate foreign tax credits. In court papers, government lawyers allege that BB&T and Wells Fargo deals were a “sham”. In Wells Fargo’s case, they assert Stars was designed so that the US bank’s “entire economic profit would be totally and exclusively sourced from US foreign tax credits”. Wells Fargo, in court papers, says its deal was a lawful reduced-cost loan.
Barclays is not a party to the cases and declined to discuss client matters or comment on its UK savings. “Barclays complies with taxation laws in the UK and all the countries where we do business,’’ the bank said. The US banks declined to comment on cases still in litigation. Washington Mutual has settled, agreeing in bankruptcy court last year to forgo $160m in claimed tax credits. Wachovia is proceeding administratively with its dispute. The other four US banks are seeking repayment for disallowed tax credits totalling more than $1bn.
The cases are a high-stakes battle for the IRS, particularly because the tax agency and the US Treasury gave notice in 1997 that it would issue more regulations on foreign tax credits to curb “abusive tax-motivated transactions”. But the IRS and Treasury never issued new regulations and in 2004 both withdrew the earlier notice.
Participants in the market say they believed the government was signalling then that it would not challenge such deals. So when the Treasury and IRS in 2007 proposed new regulations and the IRS began turning down tax credits, financial and other companies were caught unaware, they said.
US and UK tax officials declined to discuss individual cases, saying they are forbidden by law to comment. There is no sign that the UK authorities are challenging Stars deals and the UK appears to have had net tax benefit from them. One court filing by Bank of New York said: “Barclays transaction structure was reviewed by the UK taxing authority.”
More than three dozen bankers, lawyers and accountants interviewed for this article declined to speak publicly about deals that involved foreign tax credits, saying it could jeopardise their jobs. But all characterised their work as legitimate, and a sort of “cat-and-mouse” game: the authorities would close down a loophole; financiers would look for another.
“Bankers looked on it as something to make money with. Young lawyers and accountants looked on it as a game,” says one UK lawyer directly involved in the deals. “It is not hard to fool the parliamentary draftsmen.”
Foreign tax credits are designed in US law to prevent double taxation of companies that do business overseas. Because US companies are taxed on their worldwide income, they are allowed to claim credit for taxes paid in foreign jurisdictions so as to keep their tax bill essentially neutral.
But foreign tax credits have long been open to abuse. In Stars cases, for example, the IRS contends that US companies pursued “foreign tax credit generator’’ schemes to reap credits even when there was no double taxation. (The IRS is also litigating cases involving non-Stars transactions in which US firms indirectly borrowed funds from a foreign bank and received tax credit.)
Such deals have wound down because of tax probes and enhanced regulation, and because the global credit crisis changed attitudes towards risk. But a look back at Stars reveals how the deals were born and the zeal of those financiers who have been – and continue to be – eager to push the boundaries of structured finance.
The UK-US deals were crafted with confidence and ease in the mid-1990s, when financial engineers on both sides of the Atlantic saw potential for savings, recalls one participant. “The UK equivalent of a foreign tax credit generator scheme was a partnership deal,” he says. “What the US calls foreign tax credit we call double tax relief. What made the US-UK deals so attractive were the English language, a foreign tax credit system and the rules-based legal system.”
How Stars deals work
Court documents and an Internal Revenue Service legal analysis of one transaction, reviewed by the Financial Times and ProPublica, show how Stars worked. A US bank transfers assets to a trust. The bank then sells shares in the trust to UK lender Barclays and agrees to buy them back after a number of years. It also sets up a trustee in Britain. Through the trust, Barclays provides financing to the bank at below market cost. The US bank says the deal is simply a secured loan.
The transaction is designed to make use of differences between US and UK tax law. The IRS says Stars exploits them and allows for circular payments that generate tax benefits.
The US bank pays UK tax on the trust earnings and claims a corresponding US tax credit. Barclays also claims a big UK tax break. Barclays has rights to trust income, which it is required to reinvest, and claims a UK tax deduction for the reinvestment. Barclays uses part of the deduction to discount the US bank’s interest costs and keeps the rest for itself.
US banks in court filings call the discount an “offset”. In some court papers, the government calls it a “kickback” from Barclays, which is not party to the US case.
Stars deals varied but financing was always attractive. Sovereign Bank says Barclays offered a loan as much as 3.35 percentage points below market cost in 2003. BB&T received $1.5bn at 2.9 percentage points below market cost in a five-year deal that began in 2002. Wells Fargo, which received $1.25bn at 2.50 percentage points below market cost in 2002, told Judge Patrick Schiltz the deal saved it “millions of dollars in interest expense each year”.
Other financial firms participated in structured finance deals. Barclays is presented in court files as the pivotal marketer of Stars to the US banks. Court documents show Barclays at times worked with the global auditing firm, KPMG. In one case KPMG, accounting firm Ernst & Young and law firm Sidley Austin are described as involved in the design, development and marketing of the transaction. None of the three firms is the focus of an IRS challenge, and all declined to comment.
In the past decade, Barclays was known for a bold approach to tax arbitrage – the art of playing one country’s tax laws off against another. Its structured finance team was considered among the most aggressive of global moneymakers.
The bank’s Structured Capital Markets unit was led in the 1990s by Roger Jenkins, whose focus on corporate tax planning made him reportedly one of London’s highest paid financiers. Iain Abrahams, a tall Scot who joined the bank’s investment arm in 1995, was considered the wizard behind the deals, according to half a dozen people who worked or did business with him.
Mr Abrahams remains a senior executive at Barclays Capital; Mr Jenkins left in 2009. US government lawyers are seeking depositions from at least seven Barclays employees. The bank would make no employee available for interview. Mr Jenkins declined to comment.
Unaware for years
The IRS – and some of its counterparts elsewhere – was unaware for years that banks and other financial firms relied so heavily on foreign tax credits, bankers and officials said in interviews.
AIG is characterised as a pioneer in structuring transactions with foreign tax credits, arranging deals as early as 1993, according to court documents. At the helm of its development unit was a young Joseph Cassano, the financier who later headed the London-based AIG finance unit that imploded so spectacularly in 2008. Companies such as Hewlett-Packard, the global technology group, also engaged in the transactions. Banks were the most frequent partners.
A turning point came in the late 1990s, when banks realised they could do deals with each other. Knowledgeable senior bankers said they were eager to move away from corporate customers, who were less adept at structuring complex deals. “It became a cosy world,” says one. “You are dealing with your friends. You chat together, play golf together and move around each other’s institutions.”
Over time, sharp reductions in interest rates encouraged much bigger deals to create the same tax benefits. In the early 1990s, deals were $150m- $200m in size; by 2003, they were 10 to 20-fold bigger, say two bankers active in the market.
Banks also copied each other’s deals. “It was just like the credit boom,” says one prominent financier. Accountancy and law firms were involved, according to marketing documents and court papers reviewed by the FT and ProPublica.
The authorities tried to catch up. In 2004, the UK, US, Canada and Australia formed a Joint International Tax Shelter Information Centre to curb abusive transactions. Soon after, the US tax authority was alerted to questionable transactions by its British counterparts in Revenue & Customs.
The UK later passed measures that caused a “large portfolio’’ of AIG transactions in Britain to be terminated, according to public filings. The US began its own investigations, and was helped by the international effort.
The joint tax centre uncovered multiple possible cases that could have an impact on the US tax base. The Americans were alerted to “things we would never have picked up or would have been picked up years down the road”, IRS commissioner Mark Everson told the FT in 2005.
In 2006, he informed the US Senate finance committee that the IRS was “aware of 11 structured financing transactions with an estimated $3.5bn at issue”. Not long after that, the IRS began denying Stars tax credits. In 2008, it noted in a memorandum that foreign tax credit deals had caused a “significant drain on the US Treasury”.
Bankers and advisers say that tax-driven structured finance is now a fringe activity. Bill Dodwell, head of tax policy at professional services firm Deloitte, says that in the current financial climate: “I don’t think aggressive planning will come back seriously for years and years.”
Dave Hartnett, permanent secretary for tax for the Revenue, sees closer co-operation among tax authorities as helping quell the deals. But revenue authorities recognise the market forces at play, he says.
“There has been increased tax transparency from many banks,’’ he adds. “But have foreign tax credit generators been closed down completely? No, I don’t think so.” The international task force, he says is still “busy exchanging information”.
Tomorrow: Read about the wider context of corporate tax strategies, including how US companies direct profits overseas using the so-called “check the box” regime, and how the OECD is co-ordinating efforts to combat tax avoidance. This series is a collaboration by the FT and ProPublica, an independent non-profit organisation that produces investigative journalism.
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