- Quick Take
- U.S. Tax Court decides against BNY Mellon in the high-stakes lawsuit by the IRS
- Although the world’s largest custody bank intends to appeal the decision, it will have to create a $850 million reserve as a result of the verdict
- As BNY Mellon normally reports a quarterly net income in the range of $650-$700 million, this charge will result in a loss for Q1 2013
The taxman never forgets your dues. The Bank of New York Mellon Corporation (NYSE:BK) learnt this the hard way when the U.S. Tax Court sided with the Internal Revenue Service (IRS), in a lawsuit alleging that the global custodian had exploited tax provisions more than a decade ago for a $900 million benefit.  The lawsuit targeted a $1.5 billion loan to BNY Mellon, arranged by Barclays (NYSE:BCS) and KPMG in 2001-2002, for the sole purpose of generating millions in foreign tax credits (see BNY Mellon’s Legal Troubles Start To Pile Up).
The verdict will force BNY Mellon to set aside $850 million in after-tax reserves related to the tax evasion charges, which will push its numbers for the quarter into the red. And with this win on its side, the IRS will next take up this issue with the other banks – including Wells Fargo (NYSE:WFC), BB&T (NYSE:BBT) and Sovereign Bank – who received similar loans from Barclays to help them save on taxes. ((BNY Mellon readies defense of $900 million tax benefit, Reuters, Mar 20 2012))
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We maintain a $27 price estimate for BNY Mellon’s stock, which is slightly below current market price.
The Tax Arrangement Was Admittedly Brazen
Around the beginning of this millennium, the British bank Barclays, handed out loans to several banks as part of what it called Structured Trust Advantaged Repackaged Securities (STARS) deals. These loans featured a complex series of transactions which allowed a bank to cash-in on tax benefits arising from double taxation treaties between countries. The level of benefits on offer is clear from the fact that BNY Mellon amassed tax benefits of $900 million within two years on a loan of $1.5 billion.
But the fact that STARS deals were floated to exploit taxes and were not of any economic interest to the bank taking them becomes quite evident when evaluate that as a part of the deal. There were times when Barclays was actually paying BNY Mellon to take its money – something that the IRS was quick to catch. In another instance, the IRS mentions how BB&T claimed a dollar in tax credits for every fifty cents in actual taxes paid. 
And Now BNY Mellon Is Liable To Pay Up For The Tax Benefits
The court’s decision reverses the $900 million in tax benefits that BNY Mellon gained early last decade, something that works out to an after-tax liability of $850 million for the bank today after factoring in the interest for the period. This is a considerably large figure to hit the bank’s income statement given the fact that it reported a total net income of $2.4 billion for full year 2012. And although the bank maintains that the “tax treatment of the transaction was consistent with statutory and judicial authority existing at the time” and will appeal against the decision, it will have to set aside the $850 million amount as a reserve for the time being.
This will have a direct impact on BNY Mellon’s total expenses for the year. We represent expenses in our analysis of the bank as a percentage of total revenues as shown in the chart above. And the one time impact of this verdict will be seen on the bottom line as non-interest expenses increase to at least 80% of revenues for this year from our current estimate of under 76%.Notes:
- Bank of New York loses bid for $900 million tax benefit, Reuters, Feb 11 2013 [↩]
- Did Barclays Help U.S. Banks Get Undeserved Foreign Tax Credits?, ProPublica, Sep 25 2011 [↩]