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A new entry to the repo underworld

To Lehman Brothers’ repo 105’s and Lee Farkas’ repo fakes, we can now add Barclays’ repo stars.

All are transactions viewed by regulators as trickery and deceit.

Stars are explained in “Global taxation: Fiscal frustrations” by Megan Murphy and Jeff Gerth, Financial Times and ProPublica, April 15:

In November 2001, Bank of New York, a mid-tier US bank, transferred nearly $8bn of its own assets to a trust in the small, business-friendly state of Delaware through several layers of newly created companies….

It was a critical first step in setting up a complex structure known as Stars – structured trust advantaged repackaged securities, to give its full, tongue-twisting name – which US tax authorities claim was used by several American banks as an abusive tax shelter that has cost them more than $1bn in tax revenues in the past decade.

Repos were a key feature of the Stars structure.

Murphy and Gerth continue:

Today, BNY will square off against the Internal Revenue Service in US Tax Court convened in New York over Stars and the tax benefits the structure triggered for the US bank and UK-based Barclays, its counterparty in the deal. At issue is whether Stars was set up primarily to generate artificial foreign tax credits, as the IRS contends, or whether it was a legal way for BNY to obtain financing at rock-bottom rates.

The story by Murphy and Gerth is the most recent in a Tax Wars series by the Financial Times and ProPublica that began in September. Although the series is about much more than repurchase agreements, it introduced RepoWatch to at least two ways bankers can use repos to game the tax laws.

The two ways are described by the Organization for Economic Co-operation and Development in its 2009 report “Building Transparent Tax Compliance by Banks.” They are:

(1) Cross border sale/repurchase (“repo”) arrangement:

Using a circular flow of EUR 2 billion, two banks convert a EUR 1 billion inter-bank loan into a EUR 3 billion complex arrangement, part of which is a cross-border transaction that has the effect of a sale/repurchase (“repo”) arrangement. This part of the transaction is considered as a collateralised loan in one jurisdiction and as a sale & repurchase of shares in the other. The proceeds from the final sale of the underlying securities under the “repo” transaction are treated as deductible interest for the “borrower” and capital proceeds in the hands of the “lender”,  for whom capital gains are tax free.

(2) United States of America foreign tax credit (FTC) generator scheme:

The Intermediaries Study has previously described some arrangements which generate foreign tax credits for a bank. More aggressive arrangements of this kind have emerged, including the well-publicised example of highly structured FTC generator schemes used by United States taxpayers. It involves the taxpayer intentionally incurring foreign tax even where there is no or significantly less foreign tax in the basic underlying transaction, in a manner that allows the parties to obtain duplicate tax benefits and share the economic burden of the tax payments.

Stars belong to the second category, as “foreign tax credit generators,” prosecutors say. Barclays proposed the idea, and six U.S. banks participated: Bank of New York, BB&T, Sovereign (now part of Santander), Wachovia (now part of Wells Fargo), Washington Mutual and Wells Fargo.

The IRS includes foreign tax credit generators in its “High Risk Transactions” category, which it says “pose the highest compliance risk across multiple Large Business and International Industries and generally include large numbers of taxpayers, significant dollar risk, substantial compliance risk, or are high visibility.”

A complaint filed March 30, 2010, in BB&T’s case against the IRS for “erroneously and illegally” assessing BB&T $688 million in taxes and penalties, explains Barclays’ Stars transaction with BB&T and the role played by repurchase agreements, also called forward sales agreements in some court documents.

A Financial Times multimedia presentation describes the deal in plain English.

The Bank of New York case is Bank of New York Mellon v. Commissioner of Internal Revenue, Docket No. 026683-09 in U.S. Tax Court in New York.

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