Wall Street Firms Involved in Tax Dodge, Probe Says (Update2)
By Alison Fitzgerald
Sept. 11 (Bloomberg) -- Lehman Brothers Holdings Inc., UBS AG and Merrill Lynch & Co. are among Wall Street firms that concocted derivatives and stock-loan deals to help offshore hedge funds dodge hundreds of millions of dollars in U.S. taxes, according to a U.S. Senate committee investigation.
The Internal Revenue Service looked the other way while securities firms sold complicated financial products designed to skirt a law requiring them to withhold U.S. taxes on stock dividends paid to offshore investors, said Senator Carl Levin, chairman of the Permanent Subcommittee on Investigations.
Levin, a Michigan Democrat, said he wants the IRS to pursue back taxes or penalties against Wall Street firms and their hedge-fund clients that got around a 30 percent dividend tax.
``We are going to press the IRS to go after what is obviously a scheme,'' Levin said, while briefing reporters yesterday about the committee's yearlong probe. ``The IRS should be going after this. They are not. They have been pussyfooting around this.''
Citigroup Inc., Morgan Stanley, and Deutsche Bank AG also profited by creating and selling ``dividend-enhancement'' products with no legitimate investment purpose besides letting investors avoid taxes, the committee report said.
Morgan Stanley's dividend-enhancement products generated $25 million of revenue for the company in 2004 alone, and cost the U.S. government more than $300 million in unpaid taxes from 2000 through 2007, the report said.
Lehman Brothers, in an internal document described in the Senate report, estimated that it helped clients avoid $115 million in taxes in 2004. Lehman spokeswoman Monique Wise declined to comment on the report.
Dividend-enhancement transactions earned about $5 million of profit for UBS in 2005, and $4 million for Deutsche Bank in 2007, the report said.
Levin said he plans to introduce legislation making it harder to structure swaps and stock loans for the sole purpose of avoiding taxes.
At a hearing today, executives from three hedge funds, Highbridge Capital Management LLC, Angelo Gordon & Co. and Maverick Capital, Ltd., said the investment firms in the report, and many others, marketed the products to their companies to win their business.
``Every major financial institution would come and try to convince us to buy these products,'' said Joseph Manogue, treasurer of Dallas-based Maverick Capital. He said the primary reason his firm bought the products was to boost dividend returns and that most swaps lasted 15 to 30 days.
The committee released hundreds of letters and internal e- mails from the hedge funds, investment firms and their tax advisers.
Lehman's Global Tax Director John DeRosa testified at a hearing today that the current tax law surrounding swaps and stock loans is ``clear.''
``They do not attract withholding tax,'' he said.
He said the company developed strict guidelines regarding how offshore investors could engage in a swap and that Lehman refused to enter into swap or stock loans for short periods surrounding dividend payment dates.
The dividend tax applies to offshore investors who don't pay U.S. taxes on interest or capital gains. The 30 percent rate generally only applies to investors based in countries that don't have a tax treaty with the U.S., Levin said.
Tax authorities have ``a number of investigations under way'' involving issues cited in the committee report, IRS spokesman Frank Keith said. ``The IRS intends to aggressively pursue transactions that it believes to be abusive.''
Citigroup, aware the IRS might deem its so-called dividend- uplift transactions to be illegal, voluntarily disclosed them and paid $24 million in withholding taxes for 2003 through 2005, the report said.
Citigroup spokesman Daniel Noonan said the bank treated the transactions properly. ``The report recognizes that there are ambiguities in how the law should be applied,'' Noonan said in an e-mail statement. ``We support efforts by the IRS, Treasury and Congress to clarify the proper tax treatment.''
In one kind of dividend-enhancement product, offshore hedge funds would sell stocks to Wall Street firms near the time for a dividend payment. At the same time, the securities firms entered into swap contracts in which, for a fee, they agreed to pay investors the equivalent of the dividend plus any stock gains.
The swaps changed the definition of the income under IRS rules, letting offshore funds claim they didn't earn dividends subject to the 30 percent withholding tax. The Wall Street firms, in turn, might owe taxes on the dividends -- at the lower, 15 percent rate for U.S. taxpayers -- while claiming even larger deductions for the swap payments to investors.
Some firms helped clients avoid the tax through stock-loan transactions that used more steps and more complex structures to make it harder to trace any wrongdoing, according to the report.
The dividend-enhancement business got a boost in 2004, when Microsoft Corp. announced a special $3 dividend. Securities firms, including Morgan Stanley and Lehman, saw a huge business opportunity, according to e-mails quoted in the Senate report.
A Morgan Stanley e-mail called Microsoft's dividend ``a great opportunity,'' the report said. Another e-mail said Morgan Stanley employees shouldn't enter into swaps too close to the date of Microsoft's payment.
``We do not want to put on trades close to record date. Tax risk increases dramatically,'' the e-mail said, according to the report.
The committee released a series of e-mails from Maverick Capital with the subject line ``Microsoft strategy on capturing the $3.00 dividend for non U.S. holders only.''
The e-mails showed that several firms were vying for Maverick's business. ``Jim has been working on this for the last 2 months and he got UBS to match the more aggressive offers we were getting from the street,'' one e-mail read. ``We lent the stock out and will get 97% of the dividend.''
Morgan Stanley ``fully complied and continues to comply with all relevant tax laws and regulations,'' spokesman Mark Lake said.
Firms marketing the products and hedge funds buying them knew they risked being accused of tax evasion, the report said. Lehman instituted a ``tax risk'' cap permitting only $25 million of such transactions per year, the report said. That limited the company's additional tax liability if the IRS determined the transactions were illegal.
Merrill Lynch, promoting a product it called ``Gemini,'' offered Olayan Group a tax-indemnification agreement and estimated that Olayan could save $7 million a year just on its Occidental Petroleum Corp. stock. Olayan, a Saudi Arabia-based fund with an office in New York, didn't buy, saying such a transaction ``would provide a strong case for the IRS to assert tax evasion,'' according to the Senate report.
Olayan spokesman Richard Hobson confirmed that the company declined to make dividend-related transactions with Merrill.
Merrill Lynch spokesman Mark Herr said the firm ``acted in good faith when we advised our clients and acted appropriately under existing tax law.''
Andrea Leung, Global Head of Synthetic Equity Finance for Deutsche Bank, told the committee today, ``I and my colleagues on Wall Street have always understood that under current law, swaps payments were not subject to withholding tax.''
UBS spokeswoman Rohini Pragasam said the company has cooperated with Levin's committee. She declined to comment on specific information in the report, which said UBS ended a Cayman Islands stock-lending program in November 2007.
Citigroup's lawyers had warned employees they couldn't buy stocks from offshore funds and promise to sell them back after the dividend payment because the IRS might see that as a tax- avoidance maneuver. An internal Citigroup audit found that some employees arranged such transactions anyway, the report found.
In a memo to the IRS that was quoted in the committee report, Citigroup said it paid the tax ``even though liability was uncertain.''