US Senate Permanent Subcommittee on Investigations: Chairman Sen. Carl Levin (D-Mich.) and Ranking Minority Member Norm Coleman (R-Minn.)

A US Senate report charges that some of Wall Street's biggest investment banks and brokerage firms -- including Morgan Stanley, Lehman Brothers, Citigroup and Merrill Lynch -- marketed allegedly abusive transactions that helped foreign hedge-fund investors avoid billions of dollars in US taxes over the past decade. The report says that $100 billion a year is lost to offshore tax abuses.

At a Thursday US Senate hearing entitled Dividend Tax Abuse: How Offshore Entities Dodge Taxes on US Stock Dividends, the Senate Permanent Subcommittee on Investigations will examine how some financial institutions have designed, marketed, and implemented transactions to enable foreign taxpayers, including offshore hedge funds, to dodge millions of dollars of taxes on US stock dividends each year. The hearing, which follows a year-long bipartisan investigation, is part of a series of Subcommittee hearings on offshore tax abuse, which costs the United States an estimated $100 billion in tax revenues every year. Subcommittee Chairman Sen. Carl Levin (D-Mich.) and Ranking Minority Member Norm Coleman (R-Minn.) will release a 77-page joint staff report detailing the findings of the investigation in conjunction with the hearing.

Transactions by Lehman Brothers, Morgan Stanley, Citigroup, Deutsche Bank, UBS and Merrill Lynch are included in the report, which calls for the Internal Revenue Service (IRS) to crack down on such tax avoidance schemes. Officials from the IRS, Lehman, Morgan Stanley, Deutsche and several hedge funds are due to testify at a hearing on Thursday.

The report is critical not only of banks and hedge funds, but also of the IRS and the Treasury Department for what the Committee calls a failure to enforce the tax law governing this area.

The report also says that a $32 billion special dividend by Microsoft in 2004 spurred many of the big banks to sell products that would allow their hedge-fund clients to avoid paying the associated taxes.

Foreigners who invest in the United States are exempt from many US taxes – they don’t pay taxes on interest earned on money deposited in a US bank, nor do they pay taxes on capital gains – but if they invest in a US company and the stock pays a dividend, US law requires the foreign investor to pay a tax on the dividend. Dividends sent abroad are supposed to be taxed at a rate of 30% in most countries, and 15% in countries having a tax treaty with the United States. In reality, however, many non-US stockholders never pay the dividend taxes they owe. The Subcommittee found that part of the reason is that US financial institutions are helping non-US clients escape paying the US taxes they owe.

Senate investigators found that the investment banks commonly entered into arrangements to give the hedge funds the economic value of dividends, without actually triggering a withholding tax on dividend payments.

“Financial gimmicks are being used to help foreign investors dodge US taxes on US dividend taxes, and it is an open secret among insiders that they can get away with it,”said Levin. “Major financial institutions have devised complex financial structures to enable their offshore clients to dodge US dividend taxes. Over the last ten years, dividend tax abuse has cost the US treasury and honest taxpayers billions of dollars in lost revenue. We need legislation to take these abusive tax avoidance gimmicks off the market, and we need to end the silence and inaction of the Treasury and IRS in the face of rampant dividend tax dodging.”

“The Subcommittee’s bipartisan investigation leaves no doubt that some institutions have taken advantage of ambiguities in US tax law and pushed the tax-avoidance envelope too aggressively,” said Coleman. “The findings are compelling and we must reevaluate the wisdom and effectiveness of the tax regime governing these complex structures, some of which are designed solely to avoid taxes. A swaps transaction with no business purpose other than the avoidance of taxes is just a bridge too far. It’s especially troubling that the IRS has failed to address many of these problems for so long; in short, it appears that the IRS dropped the ball on preventing many of these egregious schemes. Most importantly, these tax-avoidance schemes that are being used by a privileged few force millions of honest American taxpayers to shoulder a disproportionate share of the tax base, to dig deeper to maintain investment in crucial areas like healthcare, homeland security, and education. Honest American taxpayers are the victims here.”