IRS investigating broker 'gimmicks' that cheated U.S. of billions in tax

The IRS is pursuing "numerous" investigations of financial institutions that helped foreign investors avoid federal taxes on U.S. stock dividends through allegedly abusive off-shore transactions, the tax agency's top official told Congress Thursday.

IRS Commissioner Douglas Shulman made the disclosure at a Senate Permanent Subcommittee on Investigations hearing spotlighting evidence that Lehman Brothers, Morgan Stanley, Deutsche Bank, UBS, Merrill Lynch, Citigroup and other financial firms have marketed the transactions to off-shore hedge funds and other non-U.S. investors.

"The IRS has numerous active investigations of the type of transactions we are discussing today," Shulman said in response to questions by Sen. Carl Levin, D-Mich., chairman of the subcommittee.

The tax agency's investigators will also examine the potentially abusive off-shore transactions the Senate panel uncovered through its examination of scores of e-mails and other documents from major financial firms, Shulman said.

While he declined to discuss specifics of the investigations, Shulman said "when we see transactions that appear to be abusive, under my tenure, we will challenge them."

Levin welcomed the cooperation pledge. But he nonetheless contended the IRS and Treasury Department "sat on their hands" over the last decade "even as dividend tax-dodging took hold and became an open secret among market insiders."

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 said 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.

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