By Patrick Temple-West and Kevin Drawbaugh
WASHINGTON (Reuters) - A sharp tool in the U.S. government's fight against corporate tax shelters will be put to the test in the months ahead as the Internal Revenue Service grapples with four major banks over structured transactions done a decade ago with Barclays Plc.
The IRS contends the transactions, known as STARS deals, were designed purely to facilitate tax dodging. The banks say the deals were done to enhance their core businesses and are challenging the IRS over hefty tax bills it has imposed.
To pursue these cases, the IRS is relying heavily on the "economic substance" doctrine, a legal strategy that focuses less on the technicalities of particular financial structures and more on their purposes and outcomes.
The approach - bolstered recently by legislation buried inside the Obama administration's landmark 2010 healthcare bill - is a focus of keen debate among tax lawyers and accountants.
The economic substance doctrine is a "club in the closet" for the IRS that it is using too broadly, said Jasper Cummings, a tax lawyer with Alston & Bird LLP.
For the IRS, said Robert Probasco, a partner at Thompson & Knight, the doctrine is a "convenient way to dispose of cases without some of the messiness of statutory interpretation."
In the first STARS case to go to trial, the IRS won in February, chiefly on an economic substance argument. New York's BNY Mellon Corp <BK.N> had sued the tax agency to defend a $900 million tax benefit the bank had claimed stemming from STARS transactions done with London-based Barclays <BARC.L>.
The U.S. Tax Court ruled that the transactions lacked "economic substance," meaning they were done solely for tax purposes. A judge called them "a subterfuge for generating, monetizing and transferring the value of foreign tax credits."
BNY Mellon is appealing that decision. Three other banks - BB&T Corp <BBT.N>, Santander Holdings <SOV_pc.N> and Wells Fargo <WFC.N> - are challenging the IRS in separate STARS disputes.
Like BNY Mellon, the other banks are arguing that their STARS dealings were perfectly legal and meant to advance their core businesses. All four banks and the IRS declined to comment.
A decision in BB&T's case is expected later this year.
If BNY Mellon loses its appeal of the Tax Court's February decisions, "it will be the most remarkable extension of the economic substance doctrine around," Cummings said.
LOOK TO STARS
STARS is short for "structured trust advantaged repackaged securities." The IRS has accused several banks of generating artificial foreign tax credits through STARS from roughly 1999 to 2006 with Barclays' help.
Foreign tax credits are awarded to U.S. companies by the IRS to ensure that they are not taxed twice on the same profits by the U.S. government and by a foreign government.
BNY Mellon Corp said in mid-February it was taking an $850 million charge against first-quarter profits after losing its fight with the IRS. The bank said then: "We continue to believe the tax treatment of the transaction was consistent with statutory and judicial authority existing at the time."
Barclays is not a party to the STARS cases and previously has said it complies with tax laws everywhere it does business.
The STARS disputes predate the 2010 codification of, and enhancements to the economic substance doctrine written into President Barack Obama's healthcare system overhaul.
Although they will not bear directly on the STARS cases, the 2010 changes give the IRS more flexibility to prove tax avoidance and added punitive penalties of up to 40 percent of the disputed tax bill.
BB&T is fighting an $892 million STARS dispute with the IRS. The bank recognized a $281 million expense in the first quarter of 2013 as a result of the BNY Mellon decision. BB&T and IRS had closing arguments on July 30 in their court case.
Earlier this month, the government filed arguments in cases involving Santander and Wells Fargo.
(Editing by Maureen Bavdek)