Top financial institutions helped non-U.S. investors avoid billions of dollars in federal taxes due on dividends from American companies by marketing allegedly abusive offshore transactions, according to a Senate report set for release at a hearing Thursday.
E-mails and other internal records cited in the report by the Senate Permanent Subcommittee on Investigations show that Lehman Bros., Morgan Stanley, Deutsche Bank, UBS, Merrill Lynch and Citigroup were among numerous financial firms that promoted the strategies.
"These are gimmicks which are peddled by American financial institutions — designed, concocted and peddled — to deny Uncle Sam the taxes which are owed under our law," Sen. Carl Levin, D-Mich., chairman of the Senate panel, said during a Wednesday media briefing.
Levin and Sen. Norm Coleman, the subcommittee's ranking Republican, plan to introduce legislation to require an IRS crackdown on the alleged tax-avoidance tactics.
Under the U.S. tax code, foreign investors are required to pay a 30% federal tax rate on dividends they receive from American companies. But the Senate report found that financial firms have devised strategies, often equity swaps or stock loans routed through offshore transactions, to duck the tax requirement.
According to the subcommittee, the strategies developed after a 1991 IRS rule that exempted offshore institutions and individuals from federal taxes on payments received via stock swaps.
In what the report called "one of the most blatant" strategies, an offshore hedge fund executes an agreement with a financial institution several days before a U.S. firm pays its stock dividend. Under the agreement, the hedge fund sells its holdings in that stock to the financial institution while replacing the shares with a swap agreement tied to the stock's market performance.
After the dividend is issued, the offshore hedge fund gets a "dividend equivalent" equal to the amount paid by the U.S. firm, minus a fee for the financial institution. The transaction enables the hedge fund to receive as much as 97% of the dividend, instead of the 70% it would have received had federal taxes been withheld.
Days after the dividend date, the hedge fund repurchases the stock and terminates the swap.
Levin stressed that many equity swaps and stock loans are legitimate and not linked to tax evasion. But the Senate report showed that the tax advantages of equity swaps to non-U.S. clients were well-known and lucrative among financial institutions:
•Lehman Bros. calculated its Cayman Islands stock-lending operations produced $12 million in 2003 profit, and projected $25 million in 2004 gains.
When Microsoft announced a $3-a-share special dividend in 2004, a senior member of Lehman's Equity Finance Products group outlined an effort to market "dividend enhancement" products to foreign institutions seeking to avoid taxes.
"Good progress so far this morning … I have interest my side for over 30 (million) shares … the cash register is opening!!!!" one Lehman employee responded in an e-mail obtained by the subcommittee.
"Let's drain every last penny out of this (market) opportunity," the senior official wrote in a responding e-mail received by the subcommittee.
It declined to comment on the report.
•Morgan Stanley estimated $25 million in 2004 revenue from dividend transactions.