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The ‘Stars’ transactions are not the only foreign tax credit deals that have been targeted by the US tax authorities. A lawsuit between the justice department and AIG, filed in the Southern District of New York, involves transactions of more than $2bn in financing with foreign banks that resulted in $62m in tax credits.

Participants in the structured finance market say that AIG was a pioneer in the area, and some of the documents in the case read like a primer for the cross-border finance market.

The government claims that in the early 1990s, an AIG tax lawyer developed two core ideas: “How the tax laws of France and US differed with respect to certain tax benefits and, second, how these differences in legal regimes could be exploited to obtain funding at a below-market rate.”

The deals now in dispute date to 1997 and generally followed a pattern.

AIG sold preferred stock to a foreign bank, with an obligation by AIG to repurchase that stock at a later date. Under US law, the sale and repurchase agreements were considered secured loans. The same transactions, under foreign law, were treated as purchases of preferred stock by the counterparties.

The preferred stock produced dividends that largely were exempt under foreign law, a tax benefit for the foreign bank. The foreign bank then shared that benefit by lending to AIG at a lower rate. With cheaper money, AIG invested in a portfolio of assets that generated income. AIG paid foreign tax on that income, leading to tax credits.

But the government alleges that AIG “gamed the tax system” to manufacture tax benefits in the US.

“These sham transactions, which exploited differences in foreign and domestic tax laws, served no legitimate business purpose and sucked hundreds of millions of dollars from the US Treasury in the form of foreign tax credits and other tax benefits,” the justice department says in one legal filing.

AIG, by contrast, says its financial products unit engaged in “a sophisticated version of spread banking’’ – legitimately borrowing funds from foreign banks at favourable rates and then investing those funds.

That enabled AIG to earn millions of dollars in profit wholly apart from the transaction’s tax consequences, the company said in court papers. It added that the government was using rhetoric “to bias the court”.

“Different countries have different tax laws,” AIG states in one court filing. “There is nothing at all unusual or improper about parties structuring a transaction with those differences in mind to reduce the transaction’s overall tax burden.”

The justice department and AIG declined to comment on the case. AIG sued the government for a refund of tax credits the IRS had disallowed.

Who were the people who thought up these mind-bending deals at AIG? A tiny band of financial engineers and tax lawyers inside the company’s financial products unit called the Transaction Development Group.

At the helm was a young Joseph Cassano, the same financier who later headed the AIG finance unit that imploded in 2008. Mr Cassano is no longer with AIG. His lawyer declined to comment.

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