USA TODAY INVESTIGATIONS USA TODAY INVESTIGATIONS Do you have information for an investigative story? If you know details about insider trading, securities fraud, corporate wrongdoing, consumer or travel scams or similar issues, tell us. Go to tips.usatoday.com. Sen. Carl Levin USA TODAY file 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. "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. Testifying before the Senate panel Thursday, John DeRosa, Lehman Brothers' Global Tax Director, said the company "made every effort" to ensure that its policies complied with federal tax rules. • 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. Matthew Berke, Global Head of Equity Risk Management for Morgan Stanley, told the subcommittee the company's practices with regard to dividend strategies were "totally compliant" with IRS rules and "on the conservative end of the spectrum." • 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(.)" Andrea Leung, Global Head of Synthetic Equity Finance at Deutsche Bank, testified that the company's practices did not represent a tax dodge and were "entirely legal under existing law." Levin, citing ambiguities surrounding IRS rules on equity swaps and stock loans, said Shulman and Treasury officials should clarify the issue. Shulman agreed to provide a tax agency response by next year. Guidelines: You share in the USA TODAY community, so please keep your comments smart and civil. Don't attack other readers personally, and keep your language decent. Use the "Report Abuse" button to make a difference. You share in the USA TODAY community, so please keep your comments smart and civil. Don't attack other readers personally, and keep your language decent. Use the "Report Abuse" button to make a difference. Read more