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.
Reacting to Microsoft's 2004 special dividend, the head of Morgan Stanley's equity swaps group urged early action to avoid transactions timed suspiciously close to the dividend date, according to an e-mail cited by the committee.
"Although the special is slated for November, we do NOT want to put on trades close to record date. Tax risk increases dramatically," the official wrote in an e-mail cited by the subcommittee.
"We believe that Morgan Stanley's trading at issue fully complied and continues to comply with all relevant tax laws and regulations," company spokesman Mark Lake said.
•Deutsche Bank reported that its stock loans generated $4 million in 2007 profit.
A March 2007 e-mail obtained by the Senate panel showed that Deutsche Bank traders promoted dividend-related swaps: "(D)o you want to trade 1,908,100 shares of MO (Altria Group) US and 150,000 shares of RAI (Reynolds American)? We can give you 97.5% of the dividends on those names(.)"
"Our total return swaps business operates within the letter and spirit of the law, and we have policies and procedures in place to ensure that is the case," company spokesman Ted Meyer said.
Officials of the three firms are among the witnesses scheduled to testify at Thursday's hearing.