Mellon Financial Corp. says it lost a contract to process individual federal tax returns in the Northeast for the Internal Revenue Service because a breakdown in internal controls somehow caused a “significant” number of individual taxpayer returns to be hidden or destroyed.

As a result of the cancellation, the Pittsburgh company said it would have to fire or reassign 106 employees and shut down its Pittsburgh IRS processing unit.

Martin G. McGuinn, Mellon’s chairman and chief executive officer, said in a sternly worded memorandum to employees late Friday that several unidentified employees of the Pittsburgh unit had been fired after an internal investigation, and that the company was continuing to cooperate with federal investigators.

Mr. McGuinn called the incident the result of “a gross disregard” of the company’s employee code of conduct and “a failure” to follow corporate policies.

The disclosure of problems in Mellon’s IRS processing unit came one year after the General Accounting Office published a report warning the Financial Management Service — the Treasury Department unit that oversees the lockbox arrangements with financial institutions — that it needed to keep a closer watch on whether commercial banking companies were adequately safeguarding and properly processing billions of dollars of federal collections.

A spokesman for Mellon would not comment on how many tax returns were affected by the breakdown, but published reports in the Pittsburgh news media over the weekend put the number of missing returns at 1,800.

The Internal Revenue Service has 10 contracts with financial institutions to manage the lockboxes that serve as repositories for tax payments made by individuals each tax season. Last year the IRS received more than 50 million payments through this lockbox system, according to a Treasury spokesman.

Mellon had been handling the contract for the agency’s Andover, Mass., service center since 1993, Mr. McGuinn said in the memo. The company also will continue to process payments for the IRS through a center in Los Angeles, and the Pittsburgh incident has not affected Mellon’s other lockbox operations, the spokesman said.

Banking companies typically offer lockbox services as part of their corporate cash management activities. Mellon’s global cash management services generated $204 million of revenues and over $114 million of profits through the first six months of this year.

The Mellon spokesman would not provide details of the contract with the IRS, but he said the cancellation of the contract would not be material to earnings.

Mellon, which has cash management relationships with 40 federal government agencies and more than 4,000 corporations, offers lockbox services in Atlanta, Boston, Chicago, Dallas, Los Angeles, and Philadelphia.

Mr. McGuinn said in the memo that Mellon had found no evidence of check fraud or identity theft, or that any taxpayer information had been released or used improperly.

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