Sovereign Bancorp Inc. is suing the Internal Revenue Service for $235 million over tax benefits related to a cross-border tax-reducing transaction designed by British bank Barclays PLC.

Boston-based Sovereign, owned by Spain’s Banco Santander SA, says the IRS “erroneously and illegally assessed” taxes, penalties and interest for tax years 2003 through 2005 based on Sovereign’s use of a loan arrangement with Barclays that generated tax benefits for both banks.

“This case should break important new ground with respect to defining, and maybe limiting, the IRS’s powers to upend transactions that are motivated by a desire to reduce foreign taxes,” said Robert Willens, founder of Robert Willens LLC, which advises Wall Street firms on tax and accounting issues.

The Wall Street Journal in 2006 reported that Barclays used the transaction with at least nine other U.S. banks including Wachovia Corp., Wells Fargo & Co. and Bank of America Corp.

According to papers filed yesterday in U.S. District Court in Boston, Barclays loaned a Sovereign subsidiary created in Delaware $1.15 billion in 2003 and 2004 at below-market rates of 3.3 percent the first year and 3.35 percent the second year, under the London interbank offered rate.

“Barclays, a U.K. financial institution, was able to offer funding to Sovereign Bank at a rate below Sovereign Bank’s usual cost of funds because the Barclays financing allowed Barclays to obtain certain U.K. tax benefits,” the documents say.

Disputed tax credits

Sovereign says the transaction generated taxes for its U.K. subsidiary, which it paid. It later claimed foreign tax credits on its U.S. tax returns, which were denied by the IRS this year. The IRS also denied deductions for interest payments related to the loan.

The result was a $235 million tax bill for Sovereign, which it now is suing to get back.

“Unless those credits are allowed, Sovereign Bancorp will be subject to double taxation,” the complaint says.

The IRS has been stepping up enforcement of tax laws governing cross-border transactions. The agency in March 2007 identified three types of transactions, such as the one described in the Sovereign court complaint, as generating “artificial” tax benefits because they involved circular lending. The IRS at the time didn’t identify taxpayers suspected of using the transactions.

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