The BNY Mellon case was the first to go to trial since the IRS accused several U.S. banks of generating artificial foreign tax credits through loans with London-based Barclays Plc .
The IRS challenged a $900 million tax benefit claimed by BNY Mellon that stemmed from a $1.5 billion loan from Barclays. The funding was so cheap that at one point Barclays actually paid BNY Mellon to take Barclays' money, according to court papers.
The bank sued the IRS to keep the benefit, but the tax court ruled that the transactions lacked "economic substance," meaning they were done solely for tax purposes.
Tax Court Judge Diane Kroupa wrote in a 55-page decision that the transaction "was an elaborate series of pre-arranged steps designed as a subterfuge for generating, monetizing and transferring the value of foreign tax credits."
BNY Mellon said it would appeal the decision.
"We continue to believe the tax treatment of the transaction was consistent with statutory and judicial authority existing at the time," the bank said in a statement.
BNY Mellon and the other banks involved used foreign tax credits in the Barclays transactions. These are given to U.S. companies to prevent them from being double-taxed by two countries for the same income.
The $850 million charge is more than BNY Mellon has earned in any single quarter over the past three years. Net income in the first quarter of 2012 was $619 million.
The bank had previously disclosed that it might have to book a reserve of up to $850 million in the event of an unfavorable ruling in the case.
After taking the charge, the bank said it expects it will continue to be well capitalized. But its Basel III Tier 1 common equity ratio will decline by about 55 basis points.
At the end of 2012, the bank's Basel III Tier 1 common equity ratio was 9.8 percent.
The financing Barclays provided the U.S. banks centered on so-called STARS transactions - or structured trust advantaged repackaged securities. The arrangements were so opaque and complicated that a Harvard-trained federal judge in Minnesota had to call in an outside expert to help him decipher Wells Fargo'sarrangement with Barclays, court papers show.
Experts for the government pounced on the fact that Barclays sometimes paid the other banks to take its money.
The banks have argued that the loans from Barclays advanced their core business, according to court papers. Barclays offered them the opportunity to earn greater profits by providing an ultra-cheap source of funding. Any profit would be the difference between their cost of funding and what they earned on the money they invested or put out in loans, they said.
(Additional reporting by Kim Dixon and Patrick Temple-West in Washington D.C.; Editing by Lisa Shumaker and Richard Pullin)