[Senate Hearing 110-778]
[From the U.S. Government Publishing Office]
S. Hrg. 110-778
DIVIDEND TAX ABUSE: HOW OFFSHORE ENTITIES DODGE TAXES ON U.S. STOCK
DIVIDENDS
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
of the
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
----------
SEPTEMBER 11, 2008
----------
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the
Committee on Homeland Security and Governmental Affairs
S. Hrg. 110-778
DIVIDEND TAX ABUSE: HOW OFFSHORE ENTITIES DODGE TAXES ON U.S. STOCK
DIVIDENDS
=======================================================================
HEARING
before the
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
of the
COMMITTEE ON
HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
of the
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 11, 2008
__________
Available via http://www.gpoaccess.gov/congress/index.html
Printed for the use of the
Committee on Homeland Security and Governmental Affairs
----------
U.S. GOVERNMENT PRINTING OFFICE
45-575 PDF WASHINGTON : 2008
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800;
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Washington, DC 20402-0001
COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS
JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska
THOMAS R. CARPER, Delaware GEORGE V. VOINOVICH, Ohio
MARK PRYOR, Arkansas NORM COLEMAN, Minnesota
MARY L. LANDRIEU, Louisiana TOM COBURN, Oklahoma
BARACK OBAMA, Illinois PETE V. DOMENICI, New Mexico
CLAIRE McCASKILL, Missouri JOHN WARNER, Virginia
JON TESTER, Montana JOHN E. SUNUNU, New Hampshire
Michael L. Alexander, Staff Director
Brandon L. Milhorn, Minority Staff Director and Chief Counsel
Trina Driessnack Tyrer, Chief Clerk
------
PERMANENT SUBCOMMITTEE ON INVESTIGATIONS
CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware NORM COLEMAN, Minnesota
MARK L. PRYOR, Arkansas TOM COBURN, Oklahoma
BARACK OBAMA, Illinois PETE V. DOMENICI, New Mexico
CLAIRE McCASKILL, Missouri JOHN WARNER, Virginia
JON TESTER, Montana JOHN E. SUNUNU, New Hampshire
Elise J. Bean, Staff Director and Chief Counsel
Robert L. Roach, Counsel and Chief Investigator
Ross K. Kirschner, Counsel
Mark L. Greenblatt, Staff Director and Chief Counsel to the Minority
Timothy R. Terry, Counsel to the Minority
Mary D. Robertson, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Levin................................................ 1
Senator Coleman.............................................. 6
WITNESSES
Thursday, September 11, 2008
Reuven S. Avi-Yonah, Irwin I. Cohn Professor of Law, University
of Michigan School of Law, Ann Arbor, Michigan................. 8
Joseph M. Manogue, Treasurer, Maverick Capital, Ltd., Dallas,
Texas.......................................................... 16
Richard Potapchuk, Director of Treasury and Finance, Highbridge
Capital Management, LLC, New York, New York.................... 19
Gary I. Wolf, Managing Director, Angelo, Gordon & Co., New York,
New York....................................................... 20
John DeRosa, Managing Director and Global Tax Director, Lehman
Brothers Inc., New York, New York.............................. 31
Matthew Berke, Managing Director and Global Head of Equity Risk
Management, Morgan Stanley & Co., New York, New York........... 34
Andrea Leung, Global Head of Synthetic Equity Finance, Deutsche
Bank AG, New York, New York.................................... 35
Hon. Douglas Shulman, Commissioner, Internal Revenue Service,
Washington, DC................................................. 50
Alphabetical List of Witnesses
Avi-Yonah, Reuven S.:
Testimony.................................................... 8
Prepared statement........................................... 59
Berke, Matthew:
Testimony.................................................... 34
Prepared statement........................................... 88
DeRosa, John:
Testimony.................................................... 31
Prepared statement with an attachment........................ 80
Leung, Andrea:
Testimony.................................................... 35
Manogue, Joseph M.:
Testimony.................................................... 16
Prepared statement........................................... 67
Potapchuk, Richard:
Testimony.................................................... 19
Prepared statement........................................... 70
Shulman, Hon. Douglas:
Testimony.................................................... 50
Prepared statement........................................... 94
Wolf, Gary I.:
Testimony.................................................... 20
Prepared statement........................................... 75
APPENDIX
Staff Report entitled ``Dividend Tax Abuse: How Offshore Entites
Dodge Taxes on U.S. Stock Dividends''.......................... 101
EXHIBITS
1. GHow Offshore Entities Dodge Taxes on U.S. Stock Dividends:
Swaps.......................................................... 189
DOCUMENTS RELATING TO MAVERICK CAPITAL, LTD
2. GUBS email, dated November 2004, re: Dividend Enhancement
Flow. (Attaching Dividend Enhancement.doc)..................... 190
3. GDividend Enhancement Transactions, DRAFT--AS OF 4/26/99,
prepared by Maverick Capital................................... 193
4. GDescription of Dividend Enhancement Transactions, dated
December 12, 2006, prepared by Maverick Capital................ 195
5. GMaverick Capital, Dividend Enhancement Transactions Memo,
dated June 30, 2005............................................ 197
6. GMaverick Capital emails, dated November 2004, re: Microsoft
strategy on capturing the $3.00 dividend for non-US holders
only. (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. For LDC only--we lent the stock out and will
get 97 percent of the dividend.)............................... 200
7. GMaverick Capital emails, dated June 2007, re: FIN 48 Tax
Positions--DRAFT memos......................................... 203
8. GMaverick Capital/Ernst & Young emails, dated February 2007,
re: AMTD Dividend.............................................. 211
9. GDomestic Dividend Enhancements, undated document prepared by
Maverick Capital............................................... 213
10. GExcerpts from UBS Documents regarding UBS Cayman Ltd.
(UBSCL)........................................................ 216
DOCUMENTS RELATING TO HIGHBRIDGE CAPITAL MANAGEMENT, LLC
11. GLehman email, dated November 2004, re: Highbridge Utility
Fund--Electronic Execution into CFD. (. . . also in discussions
with them around yield enhancement on their long positions by
using a CFD. This service involves tax risk for the firm which
would be reduced if we can route their electronic trades direct
to CFD instead of their PB account.)........................... 217
12. GLehman email, dated November 2004, re: Highbridge LPS
Basket. (. . . I would like to move the positions back to their
PB account. . . . Would hate to do this and find out down the
road that HB owe withholding tax on the dividends.)............ 218
DOCUMENTS RELATING TO ANGELO, GORDON & CO
13. GAngelo Gordon email, dated August 2004, re: CFDs. (a cfd is
used to circumvent the tax.)................................... 220
14. GAngelo Gordon email, dated July 2006, re: Notes from last
meeting with Anthony Harpel. (Contracts for Difference--used
mostly in offshore fund--so we don't have dividend withholding
CFD is probably about 20 percent of portfolio)................. 221
15. GLehman email, dated December 2004, re: Bloomberg internal
message sent from PATRICK RYAN. (. . . it tuns out the majority
have partial withholding so need to stay in CFD. TYPICAL!)..... 222
16. GLehman emails, dated May 2002, re: SWAPS FOR ANGELO GORDON.
(rich, I agree . . . if the positions are for longer term we
can pay 100 percent. * * * I think we have to do this to keep
AG's business)................................................. 223
DOCUMENTS RELATING TO LEHMAN BROTHERS INC
17. GEquity Finance Yield Enhancement, presentation document
prepared by Lehman Brothers Inc................................ 225
18. GLehman Brothers/Highbridge Capital email, dated July 2004,
re: CFD Presentation. (The CFD is usually used for yield
enhancement purposes. . . .)................................... 228
19. GEFG US Dividend Exposures, February 2005, Lehman Brothers
presentation................................................... 229
20. GLehman Brothers email, dated September 2005, re: MCIP. (HB
looking for Yield Enhancement on a large position.)............ 237
21. GLehman Brothers emails, dated October 2004, re: Trade
Confirm. (fyi, the only reason for HB to SWap is for yield
enhancement.).................................................. 238
22. GLehman Brothers letter to Maverick Capital, dated April 24,
2001, (Dividend Enhancement Solutions--We have a variety of
solutions using swap and securities lending vehicles for
achieving yield enhancement.).................................. 242
23. GLehman Brothers emails, dated January/February 2004, re:
Long Transfers. (. . . tell them about doing long swap/cfd
business around record date items so that they get enhanced div
treatment on us stocks. . . .)................................. 248
24. GLehman Brothers emails, dated June 2003, re: US Cayman 70
percent trade.................................................. 250
25. GLehman Brothers emails, dated January 2005, re: Conclusions
of US div meeting. (Are all the major competitors in the yield
enhancement game? * * * Borrow via Cayman is considered by Tax
dept to be lower risk than CFD in LBIE. . . .)................. 254
DOCUMENTS RELATING TO MORGAN STANLEY & CO
26. GMorgan Stanley email, dated July 2004, re: MSFT Total Return
Swaps. (Here are the main points regarding total return equity
swaps on MSFT: . . . Morgan Stanley can enhance the dividend
payout from 70 percent or 100 percent through a total return
equity swap.).................................................. 256
27. GMorgan Stanley email, dated August 2004, re: CRM (MOORE
CAPITAL)--Microsoft total return equity swap/Moore Capital..... 259
28. GMorgan Stanley email, dated July 2004, re: MSFT div timing.. 261
29. GMSDW Equity Finance Services (Cayman) Limited (``Cayco''),
Outline operating procedures, undated Morgan Stanley document.. 262
DOCUMENTS RELATING TO DEUTSCHE BANK AG
30. GDeutsche Bank email, dated October 2004, (. . . LOOKING FOR
A WAY TO MAINTAIN EXPOSURE TO MSFT BUT AVOID THE DIVIDEND
PAYMENT.)...................................................... 264
31. GDeutsche Bank emails, dated September 2004, re:
Extraordinary Dividend Rules and Microsoft One-Time Dividend... 265
32. GPROJECT: DBIL Rehypothecation, February 2007 Deutsche Bank
document....................................................... 267
33. GNew Product Application, dated January 2005, Deutsche Bank
International Limited (``DBIL'') Equity Finance alternative
structure...................................................... 268
34. GNew Product Application, dated December 2003, Deutsche Bank
International Limited, Jersey (``DBIL'') Securities Borrowing
and Lending--NPA Support document.............................. 275
35. GCorrespondence from Maverick Capitol, dated September 30,
2008, to the Senate Permanent Subcommittee on Investigations,
supplementing Maverick's testimony of September 11, 2008....... 300
36. GSupplemental information provided by the Internal Revenue
Service regarding Notice 97-66................................. 304
37. GAdditional documents regarding Citigroup, Inc............... 305
38. GAdditional documents regarding Deutsche Bank................ 308
39. GAdditional documents regarding Goldman Sachs Group.......... 321
40. GAdditional documents regarding Lehman Brothers Holdings, Inc 342
41. GAdditional documents regarding Maverick Capital Management
LLC............................................................ 396
42. GAdditional documents regarding Merrill Lynch................ 398
43. GAdditional documents regarding Morgan Stanley............... 414
44. GAdditional documents regarding UBS Investment Bank.......... 416
45. GDocuments relating to Footnotes found in the Staff Report,
Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S.
Stock Dividends, prepared by the Minority and Majority Staff of
the Permanent Subcommittee on Investigations in conjunction
with the Subcommittee hearing held on September 11, 2008:
[Note: Footnotes not listed are explanative, reference
Subcommittee interviews for which records are not available to
the public, or reference a widely available public document.].. 431
* SEALED EXHIBITS retained in the files of the Subcommittee.
Footnote No. 50, See Attachment.............................. 431
Footnote No. 51, See Footnote No. 50 (above)................. 431
Footnote No. 52, SEALED EXHIBIT.............................. *
Footnote No. 63, See Attachment.............................. 433
Footnote No. 64, See Footnote No. 63 (above)................. 433
Footnote No. 65, See Attachment.............................. 458
Footnote No. 68, See Hearing Exhibit No. 19 (above).......... 229
Footnote No. 69, See Hearing Exhibit No. 17 (above).......... 225
Footnote No. 70 and 71, See Hearing Exhibit No. 18 (above)... 228
Footnote No. 72, See Hearing Exhibit No. 13 (above).......... 220
Footnote No. 73, See Attachment.............................. 462
Footnote No. 74 and 75, See Footnote No. 73 (above).......... 462
Footnote No. 76-79, See Hearing Exhibit No. 12 (above)....... 218
Footnote No. 80, See Attachment.............................. 463
Footnote No. 81-83, See Footnote No. 80 (above).............. 463
Footnote No. 84, See Attachment.............................. 465
Footnote No. 85, See Attachment.............................. 467
Footnote No. 86, See Hearing Exhibit No. 21 (above).......... 238
Footnote No. 87, See Attachment.............................. 469
Footnote No. 88, See Attachment.............................. 471
Footnote No. 89, See Hearing Exhibit No. 20 (above).......... 237
Footnote No. 90, See Hearing Exhibit No. 22 (above).......... 242
Footnote No. 91-93, See Hearing Exhibit No. 23 (above)....... 248
Footnote No. 94, See Attachment.............................. 474
Footnote No. 95, See Footnote No. 94 (above)................. 474
Footnote No. 96, See Hearing Exhibit No. 16 (above).......... 223
Footnote No. 97, See Attachment.............................. 475
Footnote No. 98, See Attachment.............................. 478
Footnote No. 99, See Attachment.............................. 481
Footnote No. 100-102, See Hearing Exhibit No. 24 (above)..... 250
Footnote No. 103, See Attachment............................. 483
Footnote No. 104, See Footnote No. 88 (above)................ 471
Footnote No. 105, See Attachment............................. 485
Footnote No. 106 and 107, See Hearing Exhibit No. 19 (above). 229
Footnote No. 108, See Attachment............................. 487
Footnote No. 109, See Attachment............................. 489
Footnote No. 110, See Hearing Exhibit No. 17 (above)......... 225
Footnote No. 111, See Attachment............................. 492
Footnote No. 112 and 113, See Hearing Exhibit No. 19 (above). 229
Footnote No. 114, See Attachment............................. 494
Footnote No. 122, See Attachment............................. 497
Footnote No. 123, See Footnote No. 122 (above)............... 497
Footnote No. 124, See Hearing Exhibit No. 3 (above).......... 193
Footnote No. 125, See Attachment............................. 507
Footnote No. 126, See Footnote No. 125 (above)............... 507
Footnote No. 127, See Attachment............................. 510
Footnote No. 128, See Attachment............................. 511
Footnote No. 129-130, See Footnote No. 128 (above)........... 511
Footnote No. 132-134, See Hearing Exhibit No. 26 (above)..... 256
Footnote No. 135, See Hearing Exhibit No. 28 (above)......... 261
Footnote No. 136, See Attachment............................. 514
Footnote No. 137-141, See Footnote No. 136 (above)........... 514
Footnote No. 142, See Attachment............................. 518
Footnote No. 143, See Footnote No. 142 (above)............... 518
Footnote No. 144, See Attachment............................. 520
Footnote No. 146, See Hearing Exhibit No. 29 (above)......... 262
Footnote No. 147, See Attachment............................. 521
Footnote No. 148, SEALED EXHIBIT............................. *
Footnote No. 149 and 150, See Hearing Exhibit No. 3 (above).. 193
Footnote No. 151, See Hearing Exhibit No. 4 (above).......... 195
Footnote No. 152, See Attachment............................. 530
Footnote No. 153, See Footnote No. 152 (above)............... 530
Footnote No. 154, See Attachment............................. 531
Footnote No. 155, See Footnote No. 154 (above)............... 531
Footnote No. 159, See Attachment............................. 534
Footnote No. 161, See Attachment............................. 535
Footnote No. 162, See Footnote No. 147 (above)............... 521
Footnote No. 163, See Footnote No. 148 (above), SEALED
EXHIBIT........................................................ *
Footnote No. 169, SEALED EXHIBIT............................. *
Footnote No. 170, See Attachment............................. 536
Footnote No. 171 and 172, See Footnote No. 170 (above)....... 536
Footnote No. 177, See Hearing Exhibit No. 3 (above).......... 193
Footnote No. 178, See Hearing Exhibit No. 31 (above)......... 265
Footnote No. 179, See Attachment............................. 540
Footnote No. 180, See Attachment............................. 541
Footnote No. 181, See Attachment............................. 542
Footnote No. 182, See Attachment............................. 543
Footnote No. 183 and 185, See Hearing Exhibit No. 34 (above). 275
Footnote No. 186 and 187, See Hearing Exhibit Nos. 33 and 34
(above)..................................................... 268, 275
Footnote No. 188 and 189, See Footnote No. 169 (above),
SEALED EXHIBIT................................................. *
Footnote No. 190, See Attachment and SEALED EXHIBIT........ 544, *
Footnote No. 191, See Footnote No. 181 (above)............... 542
Footnote No. 192, See Footnote No. 127 (above)............... 510
Footnote No. 199, See Attachment............................. 702
Footnote No. 200, See Footnote No. 199 (above)............... 702
Footnote No. 201, See Attachment............................. 706
Footnote No. 202-204, See Footnote No. 201 (above)........... 706
Footnote No. 205, See Hearing Exhibit No. 2 (above).......... 190
Footnote No. 206, See Attachment............................. 707
Footnote No. 207, See Attachment............................. 709
Footnote No. 208, SEALED EXHIBIT............................. *
Footnote No. 209, See Footnote No. 208 (above), SEALED
EXHIBIT........................................................ *
Footnote No. 210-213, See Hearing Exhibit No. 2 (above)...... 190
Footnote No. 214, See Attachment............................. 717
Footnote No. 215, See Footnote No. 214 (above)............... 717
Footnote No. 220, SEALED EXHIBIT............................. *
Footnote No. 221, See Attachment............................. 722
Footnote No. 222, See Footnote No. 127 (above)............... 510
Footnote No. 229, See Attachment............................. 724
Footnote No. 230-233, See Footnote No. 229 (above)........... 724
Footnote No. 234, See Attachment............................. 728
Footnote No. 235, See Footnote No. 234 (above)............... 728
Footnote No. 236, See Attachment............................. 732
Footnote No. 237, See Footnote No. 236 (above)............... 732
Footnote No. 238, See Attachment............................. 735
Footnote No. 239-241, See Footnote No. 238 (above)........... 735
Footnote No. 242, See Attachment............................. 736
Footnote No. 243, See Attachment............................. 742
Footnote No. 244, See Footnote No. 127 (above)............... 510
Footnote No. 245, See Attachment............................. 743
Footnote No. 246-248, See Footnote No. 245 (above)........... 743
Footnote No. 249, See Attachment............................. 774
Footnote No. 250-254, See Footnote No. 249 (above)........... 774
Footnote No. 255, See Attachment............................. 793
Footnote No. 256, See Footnote No. 255 (above)............... 793
Footnote No. 257, See Attachment............................. 800
Footnote No. 258, See Attachment............................. 838
Footnote No. 259-261, See Footnote No. 258 (above)........... 838
Footnote No. 262, See Attachment............................. 843
Footnote No. 263, See Attachment............................. 845
Footnote No. 264-268, See Footnote No. 263 (above)........... 845
Footnote No. 269, See Attachment............................. 848
Footnote No. 270, See Attachment............................. 853
Footnote No. 271, See Attachments (2)..................... 854, 864
Footnote No. 272 and 273, See Footnote No. 271 (above).... 854, 864
Footnote No. 274, See Footnote No. 271 (above)............ 854, 864
Footnote No. 276, See Footnote No. 249 (above)............... 774
Footnote No. 277, See Footnote No. 263 (above)............... 845
Footnote No. 278, See Footnote No. 243 (above)............... 742
Footnote No. 279, See Footnote No. 127 (above)............... 510
Footnote No. 280, See Footnote No. 221 (above)............... 722
Footnote No. 285, See Attachment............................. 875
Footnote No. 286 and 287, See Footnote No. 285 (above)....... 875
Footnote No. 289, See Attachment............................. 881
Footnote No. 290, See Footnote Nos. 285 and 289 (above)... 875, 881
Footnote No. 291-298, See Footnote No. 289 (above)........... 881
Footnote No. 299, See Attachment............................. 903
Footnote No. 300, See Attachment............................. 907
Footnote No. 302, See Attachments (2) and Footnote No. 300
(above)................................................ 909, 911, 907
Footnote No. 303, See Footnote No. 299 (above)............... 903
Footnote No. 304, See Footnote No. 289 (above)............... 881
DIVIDEND TAX ABUSE: HOW OFFSHORE
ENTITIES DODGE TAXES ON U.S. STOCK
DIVIDENDS
----------
THURSDAY, SEPTEMBER 11, 2008
U.S. Senate,
Permanent Subcommittee on Investigations,
of the Committee on Homeland Security
and Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 9:10 a.m., in
Room 106 of the Dirksen Senate Office Building, Hon. Carl
Levin, Chairman of the Subcommittee, presiding.
Present: Senators Levin and Coleman.
Staff Present: Elise J. Bean, Staff Director and Chief
Counsel; Robert L. Roach, Counsel and Chief Investigator; Ross
K. Kirschner, Counsel; Mary D. Robertson, Chief Clerk; Mark L.
Greenblatt, Staff Director and Chief Counsel to the Minority;
Timothy R. Terry, Counsel to the Minority; Alexandra Brodman,
Intern; Tesia Schmidtke, Intern; and Mark LeDuc (HSGAC/Senator
Collins).
OPENING STATEMENT OF SENATOR LEVIN
Senator Levin. Good morning everybody. The Subcommittee
will come to order.
One of the problems that this Subcommittee has tackled in
recent years is the stunning fact that the United States loses
perhaps $100 billion in tax revenues each year to offshore tax
havens that aid and abet corporations and wealthy individuals
dodging payment of taxes owed to Uncle Sam.
Since 2001, this Subcommittee has examined this problem
from multiple angles, exposing the ways that people use tax
havens to hide their assets and income, and how tax havens have
created a whole industry to help them exercise control over
their offshore assets and use those assets and the revenues
they produce for their own benefit, often sneaking funds back
into the United States without paying the taxes owed. Just 2
months ago, in July, this Subcommittee held a hearing showing
how banks in offshore tax havens have knowingly helped U.S.
clients hide billions of dollars in secret bank accounts never
reported to the IRS.
Today, our spotlight is on another facet of tax haven
abuses; we call it dividend tax abuse. And the focus today is
not on U.S. citizens, but on non-U.S. citizens who are supposed
to be paying taxes on the dividends they receive from U.S.
corporations but do not. They do not pay those taxes because
major financial institutions like Lehman Brothers, Morgan
Stanley, Deutsche Bank, UBS, Merrill Lynch, Citigroup, and
others have created financial gimmicks whose primary purpose is
to enable clients to dodge U.S. taxes owed on U.S. stock
dividends, but which are dressed up with phrases like
``dividend enhancement,'' ``yield enhancement,'' and even
``dividend uplift.'' Using stock swaps, stock loans, and exotic
financial instruments, the financial institutions have built a
series of financial black boxes, surrounded by mind-numbing
complexity, designed to keep their clients' money tax free.
Foreigners who invest in the United States already enjoy a
minimal tax burden. For example, non-U.S. persons who deposit
money with a U.S. bank or securities firm pay no U.S. taxes on
the interest earned. They pay no U.S. taxes on capital gains.
U.S. citizens do pay taxes on that income, but the tax code
lets foreign investors operate without tax in an effort to
attract foreign investment.
But there is one tax on the books that even foreign
investors are supposed to pay. If they buy stock in a U.S.
company and that stock pays a dividend, the non-U.S.
stockholder is supposed to pay a tax on the dividend. The
general tax rate is 30 percent, unless their country of
residence has negotiated a lower rate with the United States,
typically 15 percent.
In addition, to make sure those dividend taxes are paid,
U.S. law requires the person or entity paying a stock dividend
to a non-U.S. person to withhold the tax owed Uncle Sam before
any part of the dividend leaves the United States. If the
``withholding agent'' fails to retain and remit the dividend
tax to the IRS, and the tax is not paid by the dividend
recipient, the tax code makes the withholding agent equally
liable for the unpaid taxes.
That is the law. But the reality is that many non-U.S.
stockholders never pay the dividend taxes that they owe. In
2003, the latest year for which data is available, the
Government Accountability Office determined that about $42
billion in dividend payments were sent abroad, but less than 5
percent, or $2 billion, was sent to the IRS. In other words,
billions of dollars left the country untaxed.
The Subcommittee's investigation has determined that part
of the reason for unpaid dividend taxes is that, for more than
10 years, U.S. financial institutions have been helping non-
U.S. clients dodge payments.
Now, listen to this roll call of well-known financial
institutions. Morgan Stanley enabled its clients to dodge
payment of $300 million in U.S. dividend taxes from 2000 to
2007. Lehman Brothers estimated that in 1 year alone, 2004, it
helped clients dodge perhaps $115 million in U.S. dividend
taxes. For UBS, the figure is $62 million in unpaid dividend
taxes over a 4-year period, from 2004 to 2007. One hedge fund
adviser, Maverick Capital, calculated that from 2000 to 2007,
its offshore funds used so-called dividend enhancement products
from multiple firms to escape dividend taxes totaling nearly
$95 million. In 2007, Citigroup surprised the IRS by paying $24
million in unpaid dividend taxes on a select group of swap
transactions from 2003 to 2005, where no dividend taxes had
been paid.
Who were the clients? Hedge funds organized offshore, often
by Americans; tax haven banks; and a host of sophisticated
foreign investors with the means and the know-how to engage in
financial transactions beyond the reach of ordinary folks. But
that is not the whole story. Some of those foreign investors
begin to look a lot less foreign once you take a closer look.
I am referring in particular to the so-called offshore
hedge funds. When the Subcommittee began contacting them, all
of their key personnel turned out to be here in the United
States. The so-called offshore hedge funds' main offices were
here in the United States; their key decisionmakers were here;
their investment professionals and technical people live here.
Most of these offshore hedge funds claim to be located in the
Caymans. The Cayman Islands, in fact, has 10,000 hedge funds,
more than any other country in the world. But the Cayman hedge
funds we examined did not operate in any meaningful sense from
the Caymans. Instead, their physical presence often amounted to
little more than a Cayman post office box or a plaque on the
wall of the infamous Ugland House, that small white building
where more than 18,000 companies maintain a Cayman address.
Hedge funds run by Americans and invested in the U.S. stock
market often create a shell of a presence in tax havens,
presumably in part to avoid paying U.S. taxes. Then, when
confronted by the one U.S. tax imposed on foreign investors
receiving U.S. stock dividends, they turn to financial
gymnastics to escape paying that tax as well. It adds insult to
injury when hedge fund managers who live in the United States,
enjoy all its benefits, protections and prosperity and use U.S.
markets to make money, arrange tax dodges so their offshore
hedge funds escape the minimal U.S. tax obligations they are
supposed to pay.
Hedge funds and other offshore entities could not perform
their dividend tax escape act without the cooperation and
assistance of financial institutions. It is those financial
institutions that devise the abusive transactions and send the
U.S. dividend payments offshore to their clients in the form of
dividend equivalent or substitute dividend payments, without
remitting any taxes to the U.S. Treasury. Their own emails show
that they took these actions knowingly to attract and retain
clients and to profit from the fees. With their assistance,
billions of dollars in U.S. dividends flowed out of this
country, and few taxes were withheld.
Now, let me just explain briefly two of the most common
schemes used to dodge dividend taxes. They involve swaps and
stock loans. In both cases, financial sleight of hand is used
to recast taxable dividend payments as untaxable transfers
offshore.
First consider swaps. Swaps sound complicated, but they are
essentially a financial bet, in this case a bet on the future
of a stock price.
If we take a look at a chart,\1\ it shows an offshore hedge
fund in blue, which is controlled by a U.S. investment manager
in green. The financial institution, shown in red, tells the
hedge fund--which owns U.S. stock--that it can escape the 30-
percent withholding tax on an upcoming stock dividend by
purporting to sell the stock to the financial institution and
simultaneously entering into a swap with the financial
institution tied to the price of that stock.
---------------------------------------------------------------------------
\1\ See Exhibit No. 1, which appears in the Appendix on page 189.
---------------------------------------------------------------------------
Under the swap, the financial institution promises to pay
the hedge fund an amount equal to any appreciation in the stock
price and the amount of any dividend paid during the term of
the swap. The payment reflecting the dividend is called a
``dividend equivalent.'' In return, the hedge fund agrees to
pay the financial institution an amount equal to any
depreciation in the stock price. The financial institution
hedges its risk by holding the physical shares of stock that
were ``sold'' to it by the hedge fund. It also charges a fee,
which usually includes a portion of the tax savings that the
hedge fund will obtain by dodging the withholding tax.
The swap gives the hedge fund the same economic risks and
rewards that it had when it owned the physical shares of the
stock. So why do it? Because under the tax code, dividend
payments are taxed, but dividend equivalent payments made under
a swap are not.
Dividend equivalent payments made under a swap are tax
free, because in 1991, the IRS issued a series of regulations
to determine what types of income will be treated as coming
from the United States and, therefore, taxable. These so-called
source rules treat U.S. stock dividends as U.S. source income
because the money comes from a U.S. corporation. But, the 1991
regulation takes the opposite approach with respect to swaps.
It deems swap agreements to be ``notional principal contracts''
and says that the ``source'' of any payment made under that
contract is to be determined, not by where the money comes
from, but by where it ends up. In other words, the payment's
source is the country where the payment recipient resides.
That approach turns the usual meaning of the word
``source'' on its head. Instead of looking at the source or
origin of the payment to determine its source, the IRS swap
rule looks to its end point--who receives it. That source is
not really a source by any known definition of the word. It is
the opposite--not the point of origin but the end point.
The result is that when a financial institution makes a
dividend equivalent payment to an offshore client under a swap
agreement, the payment is deemed under the tax code as being
from an offshore source. And then under that interpretation,
the swap payment is free of any U.S. tax.
In our example, the U.S. financial institution makes the
swap payment to the offshore hedge fund, minus the fee, and
stiffs Uncle Sam for the amount of taxes that should have been
sent to the IRS. The swap is then terminated, and the stock is
``sold'' back to the hedge fund. And the sham nature of that
sale is disclosed. And, under this gimmick, the hedge fund ends
up in the same position as before the swap, as a stockholder,
except it has pocketed a dividend payment without paying any
tax.
Now, stock loans are also used to dodge dividend taxes, and
these transactions pile a stock loan on top of a swap to
achieve the same, or are intended to achieve the same, tax-free
result. And for the sake of time I am going to put my
explanation of this transaction in the record.\1\
---------------------------------------------------------------------------
\1\ Stock Loan. Stock loans are also used to dodge dividend taxes.
These transactions pile a stock loan on top of a swap to achieve the
same tax-free result.
The first step is that the client with an upcoming dividend loans
its stock to an offshore corporation controlled by the financial
institution. This offshore corporation promises, as part of the loan
agreement, to forward any dividend payments back to the client.
The next step is that offshore corporation enters into a swap
with the financial institution that controls it, referencing the same
type of stock and number of shares that is the subject of the stock
loan. Essentially, two related parties are placing a bet on the stock,
which makes no economic sense except, once that stock pays the
dividend, the swap arrangement allows the financial institution to send
it as a tax-free dividend equivalent payment to the offshore
corporation it controls. The offshore corporation then forwards the
same amount to the client. Because the payment is sent to the client as
part of a stock loan agreement, it is called a ``substitute dividend.''
The tax code treats substitute dividends in the same way as the
underlying dividend. So if the underlying dividend came from a U.S.
corporation, the substitute dividend would normally be taxed as U.S.
source income.
---------------------------------------------------------------------------
Suffice it to say that it is complex and relies on another
gimmick, and this gimmick is that the parties claim that the
substitute dividend is tax free by invoking the wording of IRS
Notice 97-66, which was never intended to be applied to this
situation. That notice says that when two parties in a stock
loan are outside of the United States and subject to the same
dividend withholding rate, they do not have to pay the dividend
tax when passing on a substitute dividend. But the assumption
is that the tax was already paid by another party in the
lending transaction. Some tax lawyers have seized on the
wording to claim that this IRS notice, which was intended to
prevent overwithholding, could be used to eliminate dividend
withholding entirely, so long as one offshore party passes on a
substitute dividend to another offshore party subject to the
same dividend tax rate. The IRS has told this Subcommittee that
Notice 97-66 was never intended to be interpreted that way, but
in the 10 years since it was issued and abusive stock loans
have exploded, the IRS has never put that in writing.
The end result in our example is that the client pockets a
substitute dividend payment--minus the financial institution's
fee--without paying any tax. The stock loan is terminated, and
the stock is returned to the client. The big advantage of this
approach over a swap is that the client does not have to
explain why he got his stock back after the transaction. The
stock was, after all, only on loan.
Tax avoidance was clearly the economic purpose of the two
transactions just described. The client owned U.S. stock both
before and after each transaction. Neither the swap nor the
stock loan altered the client's market risk. The only risk
involved in either transaction was that Uncle Sam would catch
on and assess the dividend taxes that should have been paid but
were not.
To make it harder for Uncle Sam to catch on and prove what
is going on, financial institutions have added more complexity,
more bells and whistles, to these transactions. But the purpose
of the transactions remains the same--to enable clients to
escape paying the taxes that they owe.
And it is clear that the participants knew their
transactions were little more than tax dodging. In one email
exchange about a proposed stock loan, a potential client
informed Merrill Lynch that its tax counsel had said ``the
transaction works, as I said, once, maybe twice,'' but
``repeated use, coincidentally around dividend payment time,
would provide a strong case for the IRS to assert tax
evasion.'' Another client explaining a Lehman Brothers swap
transaction to a colleague wrote that the swap ``is used to
circumvent the tax.'' That is the unvarnished truth.
The participants in these transactions also took steps to
limit their exposure in case the IRS stepped in. Some of the
financial institutions, for example, set an annual limit on the
amount of unpaid dividend taxes that they would facilitate
through their transactions to limit their exposure as
withholding agents. Some of the clients demanded that the
financial institutions indemnify them against any tax
liability. A few financial institutions, such as UBS, Merrill
Lynch, and Morgan Stanley, have stopped offering the most
blatantly abusive transactions, while others have continued
doing as many deals as ever.
Now, some may claim that by exposing this tax dodge and
being determined to end it, we are trying to discredit
structured finance or the financial markets. I support
financial transactions that are used for legitimate purposes,
including swaps and stock loans that facilitate capital flows,
reduce capital needs, or spread risk. What I oppose is the
misuse of financial transactions to undermine the tax code, rob
the U.S. Treasury, and force honest Americans to shoulder the
country's tax burden. And what I oppose are transactions whose
patent economic purpose is tax dodging.
For the last 10 years, as dividend tax dodging took hold
and became an open secret among market insiders, the U.S.
Treasury Department and the IRS sat on their hands. When firms
began claiming they could turn taxable dividend payments into
untaxed dividend equivalents under swaps, Treasury and the IRS
said nothing. When firms began claiming that the 1997 IRS
notice designed to cure overwithholding could eliminate all
withholding in offshore stock loans, Treasury and the IRS
failed to issue corrective guidance. When firms openly
advertised so-called dividend enhancement products to clients,
Treasury and the IRS saw nothing, heard nothing, and took no
enforcement action.
The government's failure to act does not in any way excuse
the actions of the financial institutions or their clients.
They are not saved from their own abusive conduct by the
failure of regulators to stop them, any more than going through
a red light is OK if you are not caught. Nonetheless, the
silence and inaction of the Treasury and the IRS in the face of
rampant dividend tax dodging has encouraged and continues to
encourage financial institutions to offer their clients
financial concoctions designed to enable them to dodge U.S.
dividend taxes. It is past time to end that silence, to end
that inaction, and to get those concoctions off the market. It
is also past time for Congress to take on this billion-dollar
offshore tax abuse and, like so many others, enact the
legislation needed to put a stop to it.
I want to thank my Ranking Member, Senator Coleman, for his
support of this investigation, for the support of his staff,
and now invite him to make opening remarks.
OPENING STATEMENT OF SENATOR COLEMAN
Senator Coleman. Thank you, Senator Levin.
I want to begin by thanking Chairman Levin for initiating
this investigation, and I want to commend his longstanding
commitment to identifying institutions and individuals who
facilitate the inappropriate avoidance of legitimate taxes
through complex offshore schemes.
Today, we turn our attention to the findings of another
bipartisan inquiry, which the Chairman has just described: That
some U.S. financial institutions have been structuring equity
swap and loan transactions to assist their offshore clients in
avoiding U.S. taxes on stock dividends. The factual findings at
issue today and identified in this Subcommittee's bipartisan
Staff Report are compelling. They raise valid concerns that
demonstrate the need to reevaluate the wisdom and effectiveness
of tax laws and policies respecting the treatment of specific
equity swap and loan transactions.
For a foreign investor, there is a significant difference
in the United States withholding tax consequences between
investing synthetically through an equity swap versus directly
in physical U.S. equities. This difference in treatment has led
to certain abuses. While the activities may not rise to the
level of criminal tax evasion, there is no doubt that some
institutions have taken advantage of ambiguities in U.S. tax
law and pushed the tax-avoidance envelope too aggressively.
I want to be clear. Our target here today is neither
derivatives generally nor equity swaps specifically.
Derivatives serve many purposes critical to the health and
dynamism of American markets, as well as the U.S. economy, writ
large. Swaps, in particular, often offer superior leverage,
accounting treatment, market access, and transactional
efficiency, all of which--including the preferential tax
treatment afforded to swaps under current law--are legitimate
factors that may influence the decision to trade in swap form.
That said, a swaps transaction with no business purpose
other than the avoidance of withholding tax is a bridge too
far. For the most part, I am talking about a subset of
aggressively structured dividend enhancement trades that are
short-lived; clustered around dividend record dates; involve
so-called crossing in just prior to the dividend date; and
feature the reacquisition of the physical shares after the
completion of the synthetic transaction.
During the course of our investigation, we have seen these
aggressive schemes executed far too often, and, frankly, some
of the more egregious fact patterns that we have examined
reflect a shameless and cynical abuse of U.S. tax policy.
While there is no doubt that certain financial institutions
and hedge funds have crossed the line, as the Chairman has
noted, the conditions for these abuses were largely created by
Treasury and the IRS. The reality is that the state of the tax
law here is muddled; the Treasury and the IRS have known about
these ambiguities and have done woefully little to clarify the
situation, failing to offer taxpayers clear guidance and
direction. Therefore, while some financial institutions
undoubtedly raced to the bottom, Treasury and the IRS bear some
responsibility as well.
We are not just in the blame business, however. We are in
the problem identification and problem-solving business. The
Chairman has done a good job in identifying the problem. How do
we fix this problem?
In light of the Subcommittee's findings, we need a
comprehensive and in-depth analysis of the potential
legislative or regulatory responses to these abuses. The
relevant Executive Branch agencies, the congressional
committees of jurisdiction, and experts on tax law and policy
should engage in a deliberative process to evaluate the various
possible responses and determine the most appropriate path.
I strongly urge, however, that any response to these abuses
be clearly defined and carefully targeted to preserve the
integrity and efficiency of our capital markets and avoid
unintended consequences. In particular, any response should
avoid negatively impacting foreign investment in the United
States. Such investments are critical to job growth and
opportunity expansion and are undeniably necessary for the
economic well-being of our citizens.
Which brings me perhaps to the most important issue: As I
have said many times before--most recently in the
Subcommittee's hearings on tax cheats and tax shelters--
inappropriate tax avoidance by a privileged few forces millions
of honest American taxpayers to shoulder a disproportionate
share of the tax base, to dig deeper to maintain investment in
crucial areas like health care, homeland security, and
education. That tax loss sits like a millstone around the neck
of honest American taxpayers, who are struggling with high
taxes, ever-increasing gas prices, and rising health care
costs. Those honest taxpayers are the real victims here.
Thank you, Mr. Chairman.
Senator Levin. Thank you, Senator Coleman.
And now let me call our first witness to this morning's
hearing: Professor Reuven Avi-Yonah, who is the Irwin I. Cohn
Professor of Law at the University of Michigan Law School in
Ann Arbor.
Professor Avi-Yonah, I would like to welcome you back to
the Subcommittee, having testified at the Subcommittee in
August 2006 on tax haven abuses. We appreciate your sharing
your experience in international tax law and your attendance at
today's hearing. We look forward to your testimony and your
perspective on this dividend tax issue.
Before we begin, pursuant to Rule VI, all witnesses who
testify before the Subcommittee are required to be sworn, and
so at this time I would ask you, Professor, if you would please
stand and raise your right hand. Do you swear that the
testimony you are about to give before this Subcommittee will
be the truth, the whole truth, and nothing but the truth, so
help you, God?
Mr. Avi-Yonah. I do.
Senator Levin. We will use the usual timing system today,
and about a minute before the red light comes on, you will see
the light change from green to yellow, giving you an
opportunity to conclude your remarks, and your entire testimony
and the testimony of all of our witnesses will be printed in
the record. We ask you, if you would, to limit your oral
testimony to no more than 8 minutes.
Professor Avi-Yonah, please proceed with your statement.
TESTIMONY OF REUVEN S. AVI-YONAH,\1\ IRWIN I. COHN PROFESSOR OF
LAW, UNIVERSITY OF MICHIGAN SCHOOL OF LAW, ANN ARBOR, MICHIGAN
Mr. Avi-Yonah. Thank you very much, Chairman Levin and
Ranking Member Coleman, and the whole Committee and
Subcommittee for inviting me to testify today on dividend tax
abuse.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Avi-Yonah appears in the Appendix
on page 59.
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There are three basically economically equivalent ways of
investing in U.S. stock and receiving dividend or dividend
equivalent payments. The first is simply to invest in a
physical stock. A foreign buyer buys stock of a U.S.
corporation, receives a dividend, and that, as you have
indicated, Mr. Chairman, is subject to a 30-percent or
sometimes a 15-percent withholding tax. That is what our law
says.
The second alternative is to engage in an equity swap. This
is a type of transaction in which you enter into an agreement
with a financial institution, a U.S. financial institution,
under which you will at the end of the swap receive the
appreciation or pay the depreciation in the value of the stock,
and during the course of the swap, you will receive dividend
equivalents every time that the underlying stock pays a
dividend.
And the third one is a stock loan, where you have the
stock, you lend it to a U.S. institution, and in exchange you
receive dividend substitute payments.
As their names indicated, dividend equivalents are
equivalent to dividends, and dividend substitutes are
substitutes for dividends. And, economically, the foreign
investor is in the same position in all three transactions. In
all of them, they are exactly at the same level at risk for the
depreciation of the stock; they have the up side of the
appreciation of the stock; and they receive the full amount of
the dividends minus any fees that they have to pay for the
financial institutions arranging the transaction.
However, for tax purposes, as was mentioned, these
transactions are not treated alike. The actual dividend is
subject to a dividend withholding tax per the code. The
dividend substitutes are also subject to a dividend withholding
tax; they are treated as dividends based on a regulation
issued, proposed by the Treasury Department in 1992 and
finalized in 1997. But dividend equivalents on the swaps are
tax free because of the source rule that was mentioned in the
introduction.
So when you have a situation like that where three
identical, economically identical equivalent transactions are
taxed differently, there is an open invitation to taxpayers to
try to avoid the taxed ones and convert them or use the only
tax-free one. And that is an invitation to abuse, and the abuse
occurs, for example, as was mentioned, when a foreign taxpayer
actually holds a stock, sells it just before the record
dividend date, receives a dividend equivalent, and then it
reacquires the stock back. And sometimes, as was mentioned,
even sells it to the financial institution with which it enters
the equity swap and receives the dividend equivalent from that
financial institution. That is really the most extreme example,
but I would say that even if they buy and sell the stock in the
market, it does not matter, as long as they hold the actual
stock before the record date and receive it back, buy it back
after the record date and receive the dividend equivalent, that
is a dodge as well. That is an abusive transaction, in my
opinion.
Now, Treasury has been aware of this problem for a long
time. They first issued the--they created the loophole, as it
were. They issued the regulation that made dividend equivalents
under swaps tax free in 1991, as was mentioned. Already in the
preamble to the proposed 1992 regulations on stock loans, they
voiced concerns about this, and, again, in another preamble to
another regulation in 1998, they repeated their concerns. But
it has now been 16 years since the first time they voiced a
concern, and they have not really done anything.
Moreover, in 1997, they issued Notice 97-66, which has had
the effect, as interpreted by taxpayers, of making dividends
subject to payments also tax free because of what I regard as a
blatant misinterpretation of the language of the notice. But
because the notice did not say explicitly that the condition
for not withholding on dividend substitutes from one foreign
payer to another is that there will be an actual dividend
withholding somewhere in the chain, because the notice was, as
was mentioned, intended to prevent overwithholding, taxpayers
have used this to structure transactions involving stock loans
and try to avoid the dividend withholding tax this way.
Now, in my opinion, the solution is to make the three
equivalents the same; that is, dividend equivalents should be
taxed the same way the dividend substitutes are, and the
dividend substitutes are treated as dividends, so all three
should be treated as dividends. Moreover, because of the risk
that it will be possible to structure transactions involving
baskets of stock, for example, that behave equivalently to a
single stock from an economic perspective, I think we should
use the substantially similar or related property standard,
which is already well established and well developed in
regulations that is addressed to these kind of transactions.
That is, we should tax dividend equivalents whenever they are
either dividend equivalents or a single stock or in a basket of
stocks that is substantially similar or relates property to a
single share of stock.
Moreover, the IRS should clarify Notice 97-66 to make clear
that it never intended, as it states, to apply that notice to
the situation where the taxpayer cannot show that the dividend
has actually been collected anywhere in the process.
Basically, the policy issue here is, if you step back for a
moment, there is an argument--and I think it is a valid
argument, although I do not ultimately agree with it. The
argument is that we do not, as was mentioned, withhold taxes
and interest payments typically with foreigners, and we do not
withhold taxes typically by treaty and royalty payments, and
those payments are deductible. Why should we, as a policy
matter, withhold taxes on dividends when dividends are not
deductible so we already collect the corporate-level tax?
However, there is an argument that this policy is OK
because dividends represent investments in unique U.S.
taxpayers. For example, you cannot find many Microsofts in the
world, and when Microsoft pays a dividend, foreign taxpayers
would want to get that dividend, and they do not have an
alternative investment opportunities like they have in the case
of interest. But in any case, even if you disagree with the
policy analysis and think that dividends should not be subject
to withholding, that is a matter for Congress changing the law,
and for the Senate, for example, to ratify treaties maybe that
we reduce the dividend withholding to zero.
A lot of taxpayers over the years and a lot of tax policy
people have lobbied and have argued for a portfolio dividend
exemption, just like we have a portfolio interest exemption.
But, in my opinion, as long as they are not persuasive, as long
as they have not managed to persuade Congress to change the
law, it is inappropriate for taxpayers to try to use dividend
equivalents or dividend substitutes to achieve a result that
they have not been able to get Congress or the Senate to change
by way of the code or the treaty. And, moreover, it is
inappropriate for Treasury and the IRS to turn a blind eye
because one way of explaining their behavior is to say they do
not really believe in the withholding tax on dividends, and,
therefore, they allow this kind of dodge to take place. And I
think that is an inappropriate approach. It is up to Congress
to determine whether there should be withholding on dividends,
and as long as that is the law, it is up to Treasury and the
IRS to make sure the dividend withholding is, in fact,
enforced.
Thank you very much.
Senator Levin. Thank you very much, Professor. That was
very clear testimony, as always.
Financial institutions selling these financial products to
their non-U.S. clients to enable them to dodge U.S. dividend
taxes, would you agree has just become an accepted way of doing
business?
Mr. Avi-Yonah. Yes, exactly. I think that this was
identified as a problem as early as 1992 by the Treasury and as
early as 1993 in the literature. And since then, numerous
articles have been written about it, but basically what is
happening in the last 10 years is that the scope of it has
really exploded, probably because of the growth of the hedge
funds, and probably because--I once heard a tax lawyer describe
this as an ``approved loophole.'' That was the language that
was used.
The interpretation of the inaction by the Treasury and the
IRS has been that this must be an OK way of doing business.
Senator Levin. Now, take a look at Exhibit 6,\1\ if you
would, which is an email between two employees of Maverick
Capital, which runs a number of offshore hedge funds. The email
is from 2004. It describes a Microsoft special dividend
announced that year to pay $3 on every Microsoft share for a
total of $32 billion.
---------------------------------------------------------------------------
\1\ See Exhibit No. 6, which appears in the Appendix on page 200.
---------------------------------------------------------------------------
On the second page of the email, it says the following:
``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. For LDC only, we lend the stock out and will
get 97 percent of the dividend.''
Would you say that these hedge funds pressuring financial
firms, playing one off against the other to get dividend
enhancement products to relieve them of having to pay a 30-
percent dividend tax rate, that it has gotten to the point
where financial institutions have to offer dividend enhancement
products to be competitive, even if there is a tax risk?
Mr. Avi-Yonah. I believe that is the case. And, in fact,
one thing that is interesting about this is that if you watch
it over time, the fees keep declining, so that in the beginning
you can charge 15 percent and in the end you can charge 3
percent or 2 percent or 1 percent. And that is because there is
so much competition, and the hedge funds can go from one
financial firm to the other.
Senator Levin. And, that percentage that you gave was a
percentage of the dividend. Is that correct?
Mr. Avi-Yonah. That is a percentage of the dividend. So
anything above 70 prercent is good from the taxpayer's
perspective because 70 percent is what they get if they pay the
full tax. So if they get 85 percent, it is good. But, of
course, if they can get 97 or 98 percent, it is even better.
Senator Levin. Now, there is no hard data on how much the
Treasury loses based on these gimmicks, these tax avoidance
approaches to these dividends, the way these payments are
avoided. Would you estimate that this loss to the Treasury
involved billions of dollars?
Mr. Avi-Yonah. Yes, certainly. I mean, the only hard data
is the one that I believe you cited, and that is the GAO report
based on 2003 data. What they say is that in that year, $42
billion in dividends were paid to non-U.S. corporate holders.
They do not specify non-corporate holders. And of that, only
less than $2 billion was collected as withholding tax.
What is striking to me about that number is that it is less
than 5 percent, and 5 percent is typically the rate that by
treaty we collect on direct dividends, that is, dividends paid
to foreign parents of U.S. subsidiaries.
So my conclusion from that is that essentially there is no
withholding tax on portfolio dividends at all, dividends paid
on people who do not own 10 percent or more by vote of the
shares. And the reason for that is that nobody except the
hopelessly uninformed would engage in direct dividend bearing
stock investment into the United States.
What everybody does is what we have been talking about,
namely, they get dividend equivalents, and we do not have data
as to the size of dividend equivalents being paid to foreigners
because no tax is collected, so nobody has the data.
But I am convinced that billions are lost, and, in fact,
the data that the Subcommittee has collected shows that for
each bank it is hundreds of millions, or at least tens of
millions, sometimes hundreds of millions. And over time, of
course, it adds up to billions.
Senator Levin. We have lost a lot of income to the
Treasury, you estimate billions. I agree with that. What
distortions to the market result when this occurs? You have
dividends taxed, but dividend equivalents not taxed, substitute
dividends not taxed.
Mr. Avi-Yonah. The obvious distortion is that people engage
in the transactions that are not taxed and do not engage in the
transactions that are taxed. So sometimes as an economic matter
or as a business matter, they would prefer to have the actual
stock, the physical stock, or they would prefer to engage in a
direct stock loan into the United States. And since both of
these transactions are taxed, instead what they do is that they
engage in a swap, which is economically equivalent in terms of
their returns, but the terms of it and the precise business
terms may be different. Or they would engage in transactions
that are really meaningless in order to avoid the tax, like
inserting an artificial foreign entity into a stock loan
transaction so that the stock loan will be foreign-to-foreign
benefit from Notice 97-66; whereas normally they would do the
stock loan directly into the United States.
So I think the main distortions are the distortion between
the three forms of transactions, but also just useless and
wasted transaction costs when there are transactions that are
engaging only for the purpose of avoiding taxes, all of the
other transactions are just a burden on the economy.
Senator Levin. Now, these problems have been known for 10
or more years. What in your judgment is the reason that the IRS
and the Treasury have not taken this issue on and corrected it?
Is it because there is a debate over the policy? Or is it
because there is a debate over, whether that interpretation is
clearly wrong? What is the reason?
Mr. Avi-Yonah. I do not think there is a debate on the
interpretation or the fix because we know they know how to fix
it because that is what they did with dividend substitutes.
They issued the dividend substitute rule. They proposed it in
1992. They finalized it in 1997. They knew how to fix that. I
mean, before that rule, dividend substitute also could be
arguably tax free.
They made the mistake with Notice 97-66. I do not think
that was deliberate. I think they were duped, essentially, into
thinking there was an overwithholding problem that did not
really exist, and they did not think about the ways--they did
this very fast, within a month of issuing the final
regulations, so they did not really think about the way the
notice could be abused.
Fundamentally, I do think--or at least this is my surmise--
that on some level it is a policy debate. I have had this
discussion with, for example, former Clinton Administration tax
officials who told me that fundamentally the issue is whether
there should be withholding on dividends, and they do not
fundamentally believe there should be withholding on dividends
because the corporate tax is already paid and dividends are not
deductible and because we have a portfolio interest exemption
and, arguably, it is possible to convert dividends to interest
and vice versa. So, therefore, why should they try to enforce
the law in this particular regard? And as I said, I think that
is inappropriate.
Senator Levin. Now, if we decide--and I hope we do--that
the clear intent of the law is that dividends or these foreign
distributions of dividend amounts be taxed, that is the clear
intent of the law, if we decide that, how do we enforce the
law? Do we need to amend the law, particularly as it relates to
swaps? As it relates to the loans? If the Treasury refuses to
clarify their regulation, do we pass a law? Assuming that we
want to enforce the policy, which is clearly intended
currently, how do we do that?
Mr. Avi-Yonah. Well, in principle, since this is all
regulatory, it is either regulations or even just a notice,
Treasury can tomorrow, at least certainly prospectively, amend
its regulations and clarify the notice.
Senator Levin. On both swaps and----
Mr. Avi-Yonah. Yes, on both swaps and----
Senator Levin. And if they refuse to do this, as they
have----
Mr. Avi-Yonah. Then I think----
Senator Levin [continuing]. For 10 years, then what?
Mr. Avi-Yonah. Then I think legislation is appropriate, and
I think the legislation should say that dividend equivalents on
single stock swaps and on economically equivalent baskets of
stocks should be treated like dividend substitutes and that
dividend substitutes should be subject to withholding if there
is no showing that there was an actual withholding somewhere in
the chain. I think that would be appropriate.
Senator Levin. Thank you. Senator Coleman.
Senator Coleman. Thank you. Thank you, Mr. Chairman.
In some ways, this is complex. But in many ways, it is
actually pretty simple. And yet your testimony took a very
complex issue and made it very simple. There is a form of
transaction here involving dividend-paying U.S. securities, and
the Treasury and IRS have set it up so that it is very easy to
avoid the tax consequences of these transactions. And folks
have known about that for years. And the Chairman asked the
$64,000 question: Why have we not acted on this? Your response
confirms what I have been reflecting on.
Our tax policies are such that they favor foreign
investment. We want foreign investment in this country. Is that
correct?
Mr. Avi-Yonah. Yes.
Senator Coleman. So non-U.S. persons who deposit money with
a U.S. bank or securities firm do not pay tax on interest
earned or capital gains, and it almost seems to me that this
situation exists because Congress has failed to clarify this
one way or the other.
Mr. Avi-Yonah. Well, there are policy issues going in both
directions. The argument for interest is pretty clear, and that
is why since 1984 we have not been withholding on interest, and
that is that interest is simply money lent, and money can be
lent anywhere in the world, and the interest rate is basically
determined on the global market. And if we impose, try to
impose withholding taxes on interest, then either the money
will simply go somewhere else, and instead of coming here, it
will go to another one; or maybe more likely because we are a
big market, the interest cost will simply be shifted forward to
American borrowers, and they will have to bear it. And that is
not particularly good either because it increases the cost of
capital. That is the argument for interest.
And the other one for royalties, for example, which are
exempt by treaty, is that because we have a lot of intangibles
in this country developed, we benefit more from foreigners not
taxing royalties coming to us than we do by excusing royalties
paid to them. So as a revenue matter, it is a gain.
Now, dividends are different, though, because dividends are
an investment in U.S. companies. So if you take Microsoft,
which is a prominent company in these examples because it pays
very big dividends out after--the dividend tax was reduced in
2003--$32 billion, as was mentioned. Now, that particular stock
represents a unique investment opportunity. There is no other
Microsoft in the world. They have what the economists call
``rents''; that is, they have unique intangibles that they
develop--Windows software and all the rest of it--and that is
the only company that has it and the only company where you can
make that particular money.
So, in my opinion, even if we tax the dividend on Microsoft
and tax dividend equivalents on Microsoft stock, the foreigners
will still come, and they will still invest in Microsoft
because of this unique opportunity. And my judgment is that in
most situations that is the case.
In addition, one thing that needs to be investigated on the
policy level is what is the policy of our trading partners on
dividends and dividend equivalents? And at least in one case--
namely, the U.K.--I know that they tax dividends and what they
call manufactured dividends, which is dividend equivalents,
etc.
Senator Coleman. If I can follow up on that question about
whether the folks would simply accept the 30-percent haircut in
order to get Microsoft, are there close, overseas alternatives,
areas where the investors would simply shift their capital?
Mr. Avi-Yonah. Yes.
Senator Coleman. What are they?
Mr. Avi-Yonah. Well, there are, I would imagine, American
companies where you can--I mean, if you are looking at an
investment at, let's say, General Motors or Toyota or
Volkswagen, maybe they are equivalent enough so that if we tax
GM, they would shift to Toyota or shift to Volkswagen, or
Daimler or whatever. And in those kind of industries where
American companies do not have a unique competitive advantage,
there would be a risk of imposing a tax that you would be
shifting the investment elsewhere. So that is the policy debate
about whether we should be taxing dividends or not.
Senator Coleman. And that is a legitimate policy. One part
of the concern I have here--and the Chairman has done a
tremendous job of identifying the problem is: What is the
solution? I am not sure I am there yet. But one of the
solutions could simply be let's not tax dividends, treat them
like capital gains, treat them like interest, and then what you
do is you take a lot of folks out of the business, but you no
longer have the ambiguity and you no longer have agencies
involved in turning a blind eye to something that we all see
going on.
Mr. Avi-Yonah. Yes, and I think that is a legitimate
argument for Congress to have. The problem is that this
argument has been made to Congress for many years, and they
have not acted. And as long as they have not acted, I do not
think it is appropriate for taxpayers to avoid the actual
dividend tax that we have in place. Nor is it appropriate for
Treasury and the IRS to close a blind eye to these
transactions.
Senator Coleman. I do not disagree with that assertion,
Professor. Thank you, Mr. Chairman.
Senator Levin. Thank you. I think that is exactly the
issue. The IRS here is not the policymaker. They are supposed
to be enforcing the law. The law is that these dividends are
supposed to be taxable. I do not think there is any doubt about
the intent of this law. The IRS, indeed, I think knows that is
the intent. And so even though you may have a policy debate
going on in the IRS, which may be a perfectly appropriate
debate, that is not the issue before us. The issue before us is
we have a tax law, and it is being avoided and evaded by these
kinds of gimmicks which clearly are intended to avoid what is
the clear intent of the law. And the IRS, knowing that, is
doing nothing. And that is unacceptable in terms of any kind of
a separation of powers.
Mr. Avi-Yonah. Yes.
Senator Levin. You cannot have the IRS become the
policymaker. They can recommend changes in policy if they want
to, and that is a perfectly fair issue. But what they cannot do
is not enforce the law because that opens up the kind of
lawlessness which we have seen on these offshore tax havens,
which have resulted in a loss of literally, we think, of $100
billion a year. I am determined to stop that. That is the
remedy that, one way or another, I am going to fight to get
established: Enforce the tax laws. And if we want to change
them, change them. But do not evade them, do not avoid them, do
not ignore them, do not circumvent them with the use of these
transactions and concocted structures which have as their
purpose getting around the clear intent of our tax laws. This
is where we have got to fight back, and we need the IRS to help
us in that fight.
You have been very helpful in terms of clarifying what the
issues are and then distinguishing between the policy issues
and the enforcement issues.
Senator Coleman, do you have anything else?
Senator Coleman. No.
Senator Levin. Again, let us thank you for all you have
done here.
Mr. Avi-Yonah. Thank you very much.
Senator Levin. Now, our second panel of witnesses today are
Joseph Manogue--who is the Treasurer of Maverick Capital of
Dallas, Texas; Richard Potapchuk, the Director of Treasury and
Finance at Highbridge Capital Management of New York; and Gary
Wolf, who is the Managing Director of Angelo, Gordon & Co., of
New York.
If you could come and stand and raise your right hands,
please. Do you swear that the testimony you are about to give
before this Subcommittee will be the truth, the whole truth,
and nothing but the truth, so help you, God?
Mr. Manogue. I do.
Mr. Wolf. I do.
Mr. Potapchuk. I do.
Senator Levin. Thank you so much. Thank you for being here.
I think you heard me describe the timing system before, so I
will not repeat that.
Mr. Manogue, we will have you go first. Am I pronouncing
your name correctly?
Mr. Manogue. Yes, you are.
Senator Levin. Thank you. And then you will be followed by
Mr. Potapchuk. Am I pronouncing your name correctly?
Mr. Potapchuk. Yes, you are, Chairman.
Senator Levin. Thank you. And then Mr. Wolf, and then after
hearing from all of you, we will then turn to questions.
So, Mr. Manogue, please.
TESTIMONY OF JOSEPH M. MANOGUE,\1\ TREASURER, MAVERICK CAPITAL,
LTD., DALLAS, TEXAS
Mr. Manogue. Thank you. Members of the Permanent Senate
Subcommittee, my name is Joseph Manogue, and I am the Treasurer
of Maverick Capital, Ltd. I submit this statement as Maverick's
representative in response to the invitation that we received
late last week from the Subcommittee in order to assist the
Subcommittee in its review of certain industry practices that
have been commonly referred to as ``dividend enhancement
transactions.''
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\1\ The prepared statement of Mr. Manogue appears in the Appendix
on page 67.
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Maverick is an investment advisor that manages client
capital primarily through hedging strategies based on long and
short positions in U.S. and foreign equity securities. To that
end, Maverick undertakes typical industry transactions,
including the purchase and sale of stocks, shorting stocks, and
borrowing and lending stocks.
Investors in Maverick managed funds include both U.S. and
foreign institutions and individuals, and our funds include
both domestic and foreign entities in structures that are
typical for our industry. I would like to note in particular
that our structures and policies provide for investment by U.S.
taxpayers in domestic partnerships that are subject to full
Internal Revenue Service return and information reporting
requirements that typically apply in a domestic context.
In 1994, Maverick made the decision to register as an
investment adviser under the Investment Advisers Act of 1940,
and thereby voluntarily submitted to periodic review and
inspection by the Securities and Exchange Commission. Our
company prizes above all its reputation for client service and
the highest ethical standards.
In the course of its operations, Maverick utilizes the
services of a variety of prime brokerage firms that support
implementation of its trading strategy on behalf of Maverick's
client funds. These firms are among the most well-established
institutions on Wall Street. Beginning in the late 1990s and
through the subsequent years, the services offered by these
firms included dividend enhancement programs.
The proposal was as follows: U.S. tax laws subjected
dividends paid by U.S. companies to foreign stockholders to a
30-percent withholding tax. Under the relevant tax regulations,
however, foreign investors who received equivalent payments
under total return swaps and foreign stockholders of U.S.
companies who received substitute dividend payments from many
foreign stock borrowers were not subject to the 30-percent
withholding tax.
Maverick's financial institution service providers offered
to help Maverick enter into total return swap transactions that
involved Maverick's Cayman funds selling the U.S. company stock
eligible for an expected dividend to the financial institution
for a price and negotiated fees that would be substantially
equivalent to getting the value of the dividend. Alternatively,
they suggested that Maverick's Cayman Island funds should
consider lending the U.S. company stock to a Cayman affiliate
of the service provider. In consideration for the loan, the
financial institution's Cayman affiliate would pay to the
Maverick Cayman fund an amount that was somewhat less than the
dividend but exceeded the amount that it would have received
had it received the dividend net of the tax.
Maverick's tax personnel considered these proposals and
examined the tax regulations that applied to these
transactions. Taking into account their compliance with the
rules, the number of different blue chip firms offering the
services, and their assurances that the transactions had been
thoroughly vetted, there seemed to be little cause for concern
that they were legitimate.
Of the alternatives presented, however, those requiring
that the Maverick Cayman funds enter into swaps directly
presented greater complexity relating to variable transaction
terms and operational considerations than those providing for
simple stock loans. Moreover, IRS Notice 97-66 appeared to
provide express confirmation that ``substitute dividend
payments'' received with respect to stock loans to a borrower
located in the same jurisdiction as the lender would not be
subject to the withholding tax.
Thus, in 1999, Maverick began engaging in dividend
enhancement stock loans in reliance on Notice 97-66. On a case-
by-case basis, a Maverick employee would ask one of the
financial institutions that had offered to provide dividend
enhancement services whether it wished to borrow a particular
security. If the financial institution did wish to borrow that
security, Maverick would negotiate terms with that institution.
We did not engage in swaps or other cross-border transactions
for purposes of dividend enhancement, and we did not
participate in any subsequent transactions involving the
borrowed shares that may have been undertaken by the borrowers.
We engaged in these transactions through various financial
institutions until 2007. In 2007, however, the business press
published a number of reports about these programs and
suggested that the IRS was taking a close look at their
legitimacy. Understandably, the financial institutions involved
suspended the services until any questions about the industry
practices could be resolved. Maverick estimates that its Cayman
funds received approximately $63 million in substitute dividend
payments beyond the amount that they would otherwise have
received as a result of participation in dividend enhancement
stock loan transactions since 2000.
When the staff of this Subcommittee issued a request for
information earlier this year, our counsel promptly complied by
producing thousands of pages of documents. We have made our
personnel available to assist the staff in understanding
industry practices in this area and, on the basis of numerous
discussions over the past several months, believe we have
developed a candid and cooperative relationship. I am hopeful
that they have conveyed consistent impressions of Maverick to
you.
The regulation and taxation of financial transactions such
as those under discussion today are complex and evolving
subjects. As I have indicated, we believe we have acted in
accordance with the governing legal precedents and existing
guidance, but understand that those precedents may be subject
to further interpretation or revocation on the basis of further
policy review such as the one you are conducting here. Maverick
will conform to any new laws and regulations that result from
this review.
Thank you very much.
Senator Levin. Thank you. And we also want to acknowledge
the cooperation of your company. You have indeed cooperated
with the Subcommittee. We very much appreciate it, and we are
not the least bit reluctant to thank you for that.
Mr. Potapchuk.
TESTIMONY OF RICHARD POTAPCHUK,\1\ DIRECTOR OF TREASURY AND
FINANCE, HIGHBRIDGE CAPITAL MANAGEMENT, LLC, NEW YORK, NEW YORK
Mr. Potapchuk. Thank you, Mr. Chairman and Members of the
Subcommittee and staff. I want to thank you first for this
opportunity to appear before you at this hearing. My name is
Richard Potapchuk. I am the Director of Treasury and Finance at
Highbridge Capital Management, LLC.
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\1\ The prepared statement of Mr. Potapchuk appears in the Appendix
on page 70.
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Highbridge is New York-based investment adviser that
manages a group of investment vehicles more commonly known as
``hedge funds.'' We currently have $27 billion under our
management.
Over a period of many years reaching back into the 1990s,
Highbridge has used financial instruments known as ``total
return swaps'' for a variety of different investment purposes.
One such purpose, which is the subject of today's hearing, is
to gain financial exposure to U.S. dividend-paying securities
on behalf of non-U.S. investors in a manner that does not
subject certain of those distributions to these non-U.S.
investors to a dividend withholding tax of 30 percent.
Highbridge's position on this subject is set out in more detail
in my written testimony which has been submitted to you
earlier.
In these opening remarks, I would like to highlight three
points.
First, Highbridge does not design investment strategies
solely to profit from the tax status of payments received under
total return swap agreements. Our investment decisions were and
continue to be guided by our analysis of the securities to
which we want to gain economic exposure. Once these investment
decisions are made, like any other prudent investment manager
or investor, we choose a form of investment, among other
things, that is both lawful and minimizes our costs.
Second, we believe the transactions in which we engaged are
lawful. In entering into these transactions, we have prudently
sought tax advice, legal advice, and we are mindful of the
legal consensus about the transactions. In light of this
consensus, total return swap transactions have been widely used
in the financial industry for many years, as you well know.
Third is the question of whether changes in the tax
treatment of certain total return swap payments are appropriate
and/or desirable? This question is a very complicated one and
has no simple or easy answer. And, of course, it is a decision
really for you, the lawmakers and the authors of the tax code.
Highbridge will be happy to provide any information or insight
that it can to help address this question.
I am pleased, of course, to answer any questions you may
have on any of these subjects. And, again, I thank you very
much.
Senator Levin. Thank you very much, Mr. Potapchuk, and we
want to also acknowledge the cooperation of your company. We
appreciate that very much.
Mr. Wolf.
TESTIMONY OF GARY I. WOLF,\1\ MANAGING DIRECTOR, ANGELO, GORDON
& CO., NEW YORK, NEW YORK
Mr. Wolf. Thank you, Mr. Chairman. My name is Gary Wolf. I
am a Managing Director at Angelo, Gordon & Co., a Delaware
limited partnership and an SEC-registered investment adviser.
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\1\ The prepared statement of Mr. Wolf appears in the Appendix on
page 75.
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Angelo, Gordon & Co. was founded in 1988 and currently
manages with its affiliates in excess of $19 billion. We seek
to achieve attractive risk-adjusted returns while preserving
capital primarily through investments in non-traditional
strategies. Angelo, Gordon & Co. manages capital across four
principal lines: Distressed debt and par loans; real estate;
private equity; and hedged strategies. Our client base is
global and is comprised of institutions including corporations,
public funds, endowments, foundations, and high-net-worth
individuals. We have associated offices in London, Amsterdam,
Hong Kong, Seoul, Tokyo, Singapore, and Mumbai.
I joined the firm in 1993 and have been a convertible
securities research analyst and portfolio manager during the
past 15 years. Since 1995, I have been the head of the firm's
convertible securities department.
The Subcommittee has asked me to testify about one
investment product which has been offered by investment banks
for many years. The use of this product, often referred to as a
``swap'' or a ``CFD,'' has been common practice in the
financial world and was marketed to Angelo, Gordon & Co. by
many of the largest, most sophisticated investment banks in the
world. The investment banks offering these products represented
to Angelo, Gordon & Co. that the structure of these
transactions, including the tax implications, had been cleared
by their legal advisers, a position which was confirmed by our
own legal advisers. Angelo, Gordon & Co. did not construct or
market these swap products but, rather, these products were
created and marketed by the investment banks.
While the specific products offered by different investment
banks varied in particular aspects, this product in general is
one in which the investor is not the actual owner of the
security but, rather, enters into a contract with the
investment bank to receive or to make payments which mirror the
performance of the referenced security. The investment banks,
which is the counterparty to the contract, may or may not
actually hold or own the security. If the price of the security
rises, the investment bank is obligated under the contract to
pay an amount equal to that increase. If the price of the
security falls, the investor must pay the bank an amount equal
to the decline. Under the contract, an amount equal to some or
all of the value of any dividend paid to stockholders during
the contract period is paid to the investor by the investment
bank.
Depending on the specific circumstances of a given
transaction, sometimes the best way to maximize returns for our
investors was to engage in a swap transaction. While I am not a
tax expert, it is my understanding that while the person or
entity actually owning the security and receiving the actual
dividend payment may be subject to the Federal tax on
dividends, the tax treatment of a payment received under a
contract is determined by other provisions of the tax code. At
times, this tax treatment of swaps will provide a tax benefit
resulting in a higher total yield on the investment for a
foreign investor. This benefit was a central aspect of the
marketing pitches that were made to us by the investment banks.
While the tax consequences were a significant factor
considered in deciding whether to enter into a swap
transaction, this was far from the only consideration. In fact,
there were other significant economic realities that factored
into the decision to enter into a swap transaction, including
increased leverage and competitive transparency benefits. While
swap transactions do have a significant number of positive
benefits, including those related to leverage, transparency,
and tax, there are a number of potential negative consequences
or risks associated with such transactions. There was the
economic reality that since we would not be the actual owner of
the security, we would not have the normal stockholders role in
the control of the company. Also, there were often significant
transaction costs associated with swap transactions, including
the fees for leverage. In addition, unlike those situations
where we held the actual security under a swap contract, we
were exposed to the risk that our counterparty would not make
the payments called for by the contract. Recent events have
demonstrated that counterparty risk is real.
We were told by the investment banks, as well as by our own
legal advisers, that this form of investment offered a legal
way for us to enhance or maximize our total return since we
would be receiving contract payments and not actual dividend
payments. The investment strategies we pursue are not designed
around dividends but, rather, focus on movement in the price of
the equity. While the value of any dividends paid during the
time we held a position in a company would be, we hoped, minor
compared to what we would realize from the movement of the
price of the security, we were attracted to a form of
investment that resulted in lower rather than higher taxes for
our investors. Just as an individual deciding between renting
and homeownership is well advised to consider the tax
consequences of each approach, it is incumbent on financial
firms and institutions to also consider the tax consequences,
among many other factors, inherent in a given transaction.
The tax advantage of these products was certainly one of
the primary considerations that made them attractive when they
were marketed to us by the investment banks. But the tax
advantage was not the only substantive aspect of these
contracts. During the time period when Angelo, Gordon & Co. was
active in swap transactions, leverage was also a considerable
factor driving such decisions. In fact, often one of the most
important negotiation points when entering into a swap
transaction was the amount of leverage that could be obtained.
Leverage was deemed to be so critical to investment decisions
that the prime brokerage arms of investment banks would compete
for business on the basis of the amount of leverage that could
be offered.
Another significant benefit associated with swap
transactions relates to competitive transparency. When Angelo,
Gordon & Co. holds a security in swap, it prevents other
competing investors from tracking and either mirroring or
undermining our positions.
Given the myriad of benefits and positive economic results
that can be realized through swap transactions, Angelo, Gordon
& Co. engaged in such transactions on a global level, and this
activity was not simply limited to U.S. dividend-paying
securities. In fact, Angelo, Gordon & Co. has entered into swap
transactions for securities ranging from U.S. convertible bonds
to bank debt to foreign securities--none of which would be
subject to the U.S. withholding tax even if owned directly. And
this has been the case with both our domestic and foreign
funds.
My understanding is that some of the recent media
discussion regarding swap transactions has centered on the
practice of acquiring a position in a security shortly before
dividend date and then exiting that position shortly after the
dividend date, often referred to as ``bracketing'' a dividend.
Not only did Angelo, Gordon & Co. not engage in bracketing
dividends, but such a practice runs counter to Angelo, Gordon &
Co.'s core investment philosophy of focusing on well-
researched, longer-term investments. Almost always, Angelo,
Gordon & Co. would hold the security in swap for at least 9
months, and sometimes as long as 2 years. In only a handful of
instances did Angelo, Gordon & Co. hold a security in swap for
less than 30 days.
Finally, due to economic and business realities in the
marketplace, and at Angelo, Gordon, and Co. the firm currently
engages in very few swap transactions, and the number of swap
transactions engaged in has decreased significantly over time.
Given the decrease in opportunities in the marketplace, Angelo,
Gordon & Co.'s dedicated convertible securities funds, which
used to engage in such swap transactions, closed in late 2006.
Angelo, Gordon & Co.'s real estate securities funds, which also
used to engage in such swap transactions, closed in late 2007.
Notably, the significant decrease in swap transactions has had
no relationship to any change in the tax treatment of dividend-
based payments but, rather, is based on other economic and
business realities.
I hope my testimony has aided the Subcommittee in
understanding these issues, and I will do my best to answer any
questions you might have.
Senator Levin. Thank you very much, Mr. Wolf, and thank you
and your company for your cooperation also with the
Subcommittee.
Mr. Manogue, let me start with some questions to you. You
have engaged in the stock loan transactions with financial
institutions to enhance dividends for some time. Is that
correct?
Mr. Manogue. That is correct.
Senator Levin. What was the purpose of those transactions?
Mr. Manogue. The purpose of the transactions was to enhance
dividends.
Senator Levin. And how long would a typical transaction
last?
Mr. Manogue. Over the years, that has been negotiated, so
it has been different time periods. But it ranged from 30 days
down to 15 days.
Senator Levin. And then after the 15 days or 30 days, or
whatever the period was, the stock would be returned?
Mr. Manogue. That is correct.
Senator Levin. Now, when you say that the purpose of these
transactions, loan transactions, was for dividend enhancement--
and we appreciate your candor on that--the dividend itself was
not enhanced, as I understand it, but rather the amount of the
dividend was not enhanced. The enhancement came through the tax
not being paid. Is that correct?
Mr. Manogue. Through the substitute dividend payment, yes,
correct.
Senator Levin. And that not being taxable.
Mr. Manogue. Correct.
Senator Levin. Is that why that particular technique was
pitched to you by the financial institution, in order to
enhance the dividend through its not being taxable? Was that
the basis of the pitch to you from whatever financial
institution was----
Mr. Manogue. Correct. That was the premise. And I just want
to clarify one point. I am not a tax expert, so I am not sure
that a substitute dividend is not necessarily taxable.
Senator Levin. All right. But the payment that you received
was not taxable.
Mr. Manogue. Correct.
Senator Levin. OK. Now, Mr. Wolf, I wonder if you would
take a look at Exhibit 16 in the book that is in front of
you.\1\ If you look at page 2 of that exhibit where it says
that Gary Wolf called regarding the swap that was discussed?
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\1\ See Exhibit No. 16 which appears in the Appendix on page 223.
---------------------------------------------------------------------------
Mr. Wolf. Yes, sir.
Senator Levin. And he said that he--``Gary Wolf called
regarding the swap that was discussed on his prefs.''
Mr. Wolf. Yes.
Senator Levin. ``Prefs,'' what is that?
Mr. Wolf. Preferred securities.
Senator Levin. ``And he said that he is being quoted by
other brokers on the street 100-percent dividend doing it via a
total return swap as opposed to the 92 percent that we offer.
He said he would be looking to do this on a more long-term
position as opposed to ones that he knows they will be getting
out of.'' Is that accurate? Do you remember that phone call?
Mr. Wolf. Vaguely.
Senator Levin. All right. And to the extent that you
remember it, was the return on that swap important to you?
Mr. Wolf. Sure.
Senator Levin. The transactions that you engaged in there
were aimed at enhancing your dividend. Is that correct?
Mr. Wolf. That was one of the significant factors in
entering into a total return swap or a CFD.
Senator Levin. Was that, would you say, a significant
factor? Is that the way you would phrase it?
Mr. Wolf. Well, I would say it is a very significant
factor--in fact, a primary factor; but not the only economic
substance to the transaction.
Senator Levin. All right. And, Mr. Potapchuk, let me ask
you the question. Did you engage in the transactions that we
are discussing here to enhance the dividend?
Mr. Potapchuk. We do engage and have engaged for quite some
time, back into the 1990s, in transactions involving taking
exposure to securities in the form of total return swap, yes.
With respect to the stock lending transactions that were
referred to, the answer to that is no.
Senator Levin. In terms of the swaps?
Mr. Potapchuk. In terms of stock loan transactions, no.
Senator Levin. What about swaps? Did you engage----
Mr. Potapchuk. Swaps, yes. We engaged, have engaged, and
continue to engage in transactions that involve taking exposure
to securities in the form of total return swaps.
Senator Levin. All right. And the principal purpose there
was----
Mr. Potapchuk. Well, the principal purpose----
Senator Levin. The principal reason, I think your testimony
is, although not necessarily the only reason, of these total
return swaps was to reduce the tax burden on the non-U.S.
investors. Is that your testimony I am reading from?
Mr. Potapchuk. Yes. There are other economic reasons for
entering into a swap, but quite frankly, the most compelling
one by far is the tax savings. And without that tax savings, a
lot of those swaps, I would say, at Highbridge would not have
occurred.
Senator Levin. Thank you.
Mr. Potapchuk. Some would and some would not.
Senator Levin. But many of them would not have occurred?
Mr. Potapchuk. That is true.
Senator Levin. Mr. Manogue, you said that in 2007 a number
of financial institutions suspended offering dividend
enhancement services.
Mr. Manogue. That is correct.
Senator Levin. And how many stopped, and who were they?
Mr. Manogue. To the best of my knowledge, all of them
stopped.
Senator Levin. Let me ask each of you, how did your firm
learn about these types of transactions in the first place? Did
this come from a financial institution of some kind?
Mr. Manogue. Yes, financial institutions would market us
for this product.
Senator Levin. ``Mark'' you? What does that mean?
Mr. Manogue. Market.
Senator Levin. Oh, market.
Mr. Manogue. They would come up and try to convince us to
buy their product.
Senator Levin. Who are some of those institutions; do you
remember?
Mr. Manogue. Over the years they have ranged from every
major financial institutions, but, in particular, for us it was
UBS, Merrill Lynch, Morgan Stanley, Lehman Brothers, Nomura,
and ING.
Senator Levin. OK, so they initiated it, came to your
company to try to persuade you to use the type of transaction?
Mr. Manogue. Yes, they did.
Senator Levin. Mr. Potapchuk, did you initiate this or was
this a financial institution which marketed this to you?
Mr. Potapchuk. Well, as I explained, what we do at
Highbridge is enter into total return swap transactions and not
the other stock lending type transactions. We enter into total
return swaps for, again, many other reasons in many other
markets. We are very aware that under current tax law, payments
under total return swaps are not subject to dividend
withholding, so----
Senator Levin. There was not a financial institution which
came to you to market it?
Mr. Potapchuk. They all come to us to market it in the
sense that we may be doing it with someone, with a UBS company,
and they would like us to do it with them instead just to gain
some market share of our business. But once approached by any
of these firms, we have a practice whereby internally we vet
any of the issues that they bring up. We confer with our own
in-house counsel, our own in-house tax advisers. We go outside
to the extent we need to with our tax professionals. And we
basically came to the same conclusion as they did with respect
to the appropriate tax treatment of these payments under the
swap contracts.
Senator Levin. But these total swaps are marketed to you?
Mr. Potapchuk. They are marketed to us, just like a normal
prime brokerage is marketed to us, yes.
Senator Levin. And when they are marketed to you as the
principal--I will leave it there.
Mr. Wolf, how did your company get involved in the swaps?
Was this something internal, or was this marketed to you by
financial institutions?
Mr. Wolf. It was marketed to us by a number of major
financial institutions.
Senator Levin. And who are they?
Mr. Wolf. Several on this list that are--Lehman Brothers,
Deutsche Bank, Morgan Stanley, Goldman Sachs, Merrill Lynch,
and others.
Senator Levin. OK. Mr. Manogue, is Maverick LDC a U.S.
company?
Mr. Manogue. No. It is a Cayman Island entity.
Senator Levin. And how many people does Maverick have in
the Caymans?
Mr. Manogue. We do not have any.
Senator Levin. So this is a company that you own that is in
the Caymans or listed in the Caymans, but you do not have any
people there?
Mr. Manogue. Correct. It is registered in the Caymans.\1\
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\1\ See Exhibit No. 35 which appears in the Appendix on page 300
for clarification of these remarks.
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Senator Levin. Registered. Thanks. So you do not have an
office there?
Mr. Manogue. Correct.
Senator Levin. And how many people do you have in the
United States?
Mr. Manogue. Close to 200 people.
Senator Levin. And where are the investment specialists who
make all the investment decisions, perform all the investment
decisions, and perform all the research located?
Mr. Manogue. We have several offices here in the United
States. The primary office would be Dallas as well as New York
City.
Senator Levin. But all the 200 or so are in the United
States?
Mr. Manogue. Almost all of them. We do have some folks in
London, Taipei, and Shanghai.
Senator Levin. All right. Now, when you performed the stock
loan transactions with UBS, the record indicates that the
transactions were with UBS' Cayman Island facility. If you
would take a look at Exhibit 10,\2\ and this is the way UBS
described its Cayman Island facility. It said, ``UBSCL is not
licensed, registered, or regulated, e.g., by reason of capital
adequacy requirements, as a broker-dealer or similar entity in
any jurisdiction, cannot access the capital markets except
through a broker-dealer, and does not hold itself out as a
broker-dealer. UBSCL''--that is their Cayman operation--``is
not and does not hold itself out as being capable of servicing
customers, e.g., it does not possess adequate systems or
personnel. UBSCL's counterparties do not view themselves as
UBSCL's customer. And UBSCL does not have any fiduciary duties
to its counterparties. UBSCL does not make markets, possess
inventory, or have an established place of business. UBS does
not hold itself out as a merchant or as willing to enter into
either side of securities or derivative trades.''
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\2\ See Exhibit No. 10 which appears in the Appendix on page 216.
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I cannot think of a better definition of a shell than that
one.
Now, your operation in the Caymans, as you just indicated,
was a shell operation, and over the years the stock loan
transactions between the two Cayman Islands shells cost the
U.S. Government about $90 million in dividends that were not
withheld. And that loss came because the transactions
supposedly took place between the two Cayman entities. So far
are you with me?
Mr. Manogue. I am with you, Senator.
Senator Levin. OK. Do you disagree with anything I have
said so far on this question?
Mr. Manogue. Well, I am not sure what the question is,
but----
Senator Levin. Well, what I have said so far, that there
were two entities--there was a loan transaction between--one of
them was your entity, which you have described as not having
any people there and being registered there; the other one, UBS
described just the way I have just read it.
Mr. Manogue. Yes.
Senator Levin. Were you aware that UBS Cayman----
Mr. Manogue. We knew of the entity, yes.
Senator Levin. All right. Now, do the financial
institutions that Maverick has dealt with more recently also
run these trades through these kind of registered offices in
offshore jurisdictions?
Mr. Manogue. Yes.
Senator Levin. And, again, I think you have been clear that
the trades are structured through these jurisdictions as a way
of enhancing your dividend, as you put it. So I think you have
been clear on that.
Now, Mr. Wolf, does Angelo, Gordon & Co. have a Cayman
Island hedge fund?
Mr. Wolf. We have--yes.
Senator Levin. And how many people do you have in the
Caymans?
Mr. Wolf. We do not have any employees in the Caymans.
Senator Levin. Do you have an office in the Caymans?
Mr. Wolf. No. We have an administrator.
Senator Levin. No employees?
Mr. Wolf. That is correct.
Senator Levin. And about how many people work for Angelo,
Gordon & Co.?
Mr. Wolf. About 250.
Senator Levin. And none of them are in the Caymans. Where
are they?
Mr. Wolf. They are in New York, offices in London,
Amsterdam, several in Asia, Chicago, and Los Angeles.
Senator Levin. OK. Thank you.
Mr. Potapchuk, what about Highbridge? Does Highbridge have
a Cayman hedge fund?
Mr. Potapchuk. The funds that Highbridge manages are
generally registered in the Cayman Islands, yes.
Senator Levin. And how many folks do you have in the
Caymans?
Mr. Potapchuk. We have none. We have an administrator, some
legal experts, etc.
Senator Levin. But no employees there?
Mr. Potapchuk. No employees.
Senator Levin. And do you have an office there?
Mr. Potapchuk. We do not have an office there.
Senator Levin. Mr. Manogue, would you take a look at
Exhibit 7, please?\1\ Leading up to my question, Mr. Manogue,
about Exhibit 7, let me see if you would agree with this.
According to the materials that you have provided to the
Subcommittee--and, again, we appreciate that cooperation--your
firm received about $63 million in dividend enhancements. Now,
those are portions of dividends that would normally be withheld
but are not under the transactions that you engaged in, and the
financial institutions that you were trading with received
about $31 million, the portion of Maverick's enhancement that
was paid to them. That would be money, obviously, which would
have otherwise been withheld and turned over to the U.S.
Government.
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\1\ See Exhibit No. 7 which appears in the Appendix on page 203.
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Now, I want to ask you about Exhibit 7. What I have said so
far is based on your documents, and so I will proceed from
there unless you disagree with those figures that I just gave.
Mr. Manogue. I do not disagree.
Senator Levin. All right. Thanks.
Now, Exhibit 7, this is a communication between Mr.
Chisholm of Maverick and a representative from Ernst & Young.
In the memo, Mr. Chisholm raises the question of whether money
from dividend enhancement transactions should be reserved or
paid to the government as part of Maverick's tax return. And
this is what he says: ``Now that June 15th is approaching, we
are considering''--again, I am reading from Exhibit 7--
``whether we need to go ahead and remit the 2006 income tax
withholding that we accrued for FIN 48 purposes in connection
with the stock loan fee income earned during 2006. We
determined in December that we should probably accrue these
taxes even though nothing is actually withheld by our other
brokers. We will need to address whether or not to pay these
taxes for pre-2006 years whenever we file protective returns
for those years.''
Has Maverick paid any money to the government as part of a
tax payment related to these dividend enhancement transactions?
Mr. Manogue. I am not aware of that. I would have to talk
to our tax advisers and service folks.
Senator Levin. All right. Let us know then. Would you do
that for the record?\2\
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\2\ See Exhibit No. 35 which appears in the Appendix on page 300.
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Mr. Manogue. We will.
I believe this memo also is driven by a discussion on
compliance with FIN 48. There is a reserve that has been
determined that we should take related to fees that we earn for
lending our stocks out. So I believe there are two issues being
discussed in this memo.
Senator Levin. All right. Now, that same exhibit, I think
it is page 5, but at the bottom it is MAV0001119. Do you see
that page? It is in the lower right-hand corner.
Mr. Manogue. Yes.
Senator Levin. OK. Now, if you look at the top paragraph
there, this is addressed to Joe Bianco, who is a Maverick
employee. Is that correct?
Mr. Manogue. No. He works for Ernst & Young, I believe.
Senator Levin. Matt Blum at the bottom. Do you see he works
for Ernst & Young?
Mr. Manogue. As well, yes.
Senator Levin. So they both work for Ernst & Young?
Mr. Manogue. I believe so, yes.
Senator Levin. All right. As you read the first paragraph,
if the prime broker does not withhold and the IRS catches the
prime broker, then perhaps the prime broker can go after
Maverick for contribution or indemnification, complex point if
the contract is silent, but if the IRS figures out what is
going on, the IRS can bypass the prime broker and go straight
after Maverick for failure to pay tax imposed under Section
881. The only limit is that the IRS may not collect the tax
twice.
So if the IRS figures out what is going on, the IRS can go
straight after Maverick. Were you aware that was the Ernst &
Young opinion?
Mr. Manogue. I was not until preparing for this testimony.
Senator Levin. OK. Mr. Wolf, how much withholding did
Angelo, Gordon & Co. get back from these dividend enhancement
transactions over the years? Do you have that figure for us?
Mr. Wolf. For the years 2000 to 2007, the total amount of
U.S. dividends that Angelo, Gordon & Co. received in offshore
funds was $137 million. So we would have gotten contract
payments of $137 million.
Senator Levin. All right.
Mr. Wolf. Therefore, what you were calling dividend--30
percent of that number is the number.
Senator Levin. Thirty percent of that $137 million.
Mr. Wolf. Correct.
Senator Levin. And, Mr. Potapchuk, how much withholding did
Highbridge get back from the dividend enhancement transactions
over the years?
Mr. Potapchuk. The analysis that we have done and submitted
to the staff previously covered the 6-year period from 2002
through 2007, where it is indicated that if during that time
there was a 30-percent withholding requirement on payments
received on swap transactions, the likely amount of withholding
amounts that would have occurred at Highbridge would have been
approximately $100 million. And I can walk you through that
number a bit. It works like this.
We received during that period about $425 million in
payments under total return swap contracts. These were received
by our master fund. Our master fund has a combination of U.S.
and non-U.S. investors. The U.S. portion ranges from 10 to 20
percent. So let's say that 15 percent of that number, or about
$60 million, would not be subject to withholding because they
would be directly received by--they would be indirectly
effectively received by U.S. persons. That would bring us down
to about $360 million.
Additionally, there are several amounts included in those
payments received that would otherwise not be taxable. For
instance, in many cases, in particular with respect to large
dividends that are paid, many of the dividends are treated as
returns of capital for U.S. tax purposes. They are not paid out
of current earnings and profits of the corporations.
Conservatively, we estimate that about $20 million of that
total would have been made up of something classified as return
of capital by the corporations, which would bring us to $340
million, and about 30 percent of that number gets me to the
$100 million over the 6-year period ending in 2007.
Senator Levin. I have got it. And I can ask both of you,
Mr. Wolf first, was any of that $137 million ever paid back to
the government as part of a tax payment?
Mr. Wolf. Well, again, it was not the $137 million. That
was the----
Senator Levin. The 30 percent of that, was any of that ever
paid to the government?
Mr. Wolf. Not to my knowledge.
Senator Levin. All right. And do you know, Mr. Potapchuk,
if any of that approximately $100 million you talked about was
ever paid to the government?
Mr. Potapchuk. No, it was not paid to the government at
all.
Senator Levin. Thank you.
Mr. Manogue. Senator, if I may, I would like to clarify one
other point.
Senator Levin. Sure.
Mr. Manogue. We discussed Exhibit--I believe it is Exhibit
7, page MAV0001119.
Senator Levin. Yes.
Mr. Manogue. The memo from Matt Blum to Joe Bianco of Ernst
& Young. I believe after having a chance to look at this, the
first two paragraphs refer to a discussion about the reserve
for stock loan fees that have been paid in our tax return. The
last paragraph in that email exchange refers to dividend
enhancement, where they conclude that there is a need to come
up with a better than 50-percent chance of succeeding under FIN
48 analysis. So I believe the top two paragraphs are referring
to something different, not dividend enhancement.
Senator Levin. The one I read you do not think referred
to----
Mr. Manogue. I do not.
Senator Levin. But you are confident that this memo was an
internal memo at Ernst & Young?
Mr. Manogue. Yes.
Senator Levin. And that the ``Joe'' referred to is an Ernst
& Young employee?
Mr. Manogue. Joe Bianco, yes.
Senator Levin. And that these points in this memo were not
shared with you?
Mr. Manogue. They were not shared with me, no.
Senator Levin. I mean with your company.
Mr. Manogue. I believe they were shared and through the
email chain would have gotten to our tax department.
Senator Levin. Who in your tax department? Who in that
email chain----
Mr. Manogue. Keith Hennington and Chad Chisholm.
Senator Levin. So your tax department was aware of this
document, then?
Mr. Manogue. Yes.
Senator Levin. OK. Let me again thank our witnesses, and I
would note that these hedge funds are not the only hedge funds
that engage in these activities. These are representative of
these actions and activities that go on, and we selected three
because we needed to have representative witnesses here, and
you have been helpful. We appreciate it and you are excused.
Mr. Manogue. Thank you.
Mr. Potapchuk. Thank you.
Mr. Wolf. Thank you.
Senator Levin. Let me now welcome our third panel of
witnesses: John DeRosa, the Managing Director and Global Tax
Director of Lehman Brothers, New York; Matthew Berke, the
Managing Director and Global Head of Equity Risk Management of
Morgan Stanley of New York; and Andrea Leung, the Global Head
of Synthetic Equity Finance of Deutsche Bank of New York.
Let me thank each of you again for being here today, and
pursuant to Rule VI, all witnesses who testify before the
Subcommittee are required to be sworn. So I would ask that you
please stand and raise your right hand. Do you solemnly swear
that the testimony that you will give to this Subcommittee
today will be the truth, the whole truth, and nothing but the
truth, so help you, God?
Mr. DeRosa. I do.
Mr. Berke. I do.
Ms. Leung. I do.
Senator Levin. Thank you.
I think you were all here when we described the timing
system, so I will not repeat that. Mr. DeRosa, we will have you
go first, followed by Mr. Berke, and then Ms. Leung. And then
we will turn to questions.
So, Mr. DeRosa, you may proceed.
TESTIMONY OF JOHN DeROSA,\1\ MANAGING DIRECTOR AND GLOBAL TAX
DIRECTOR, LEHMAN BROTHERS INC., NEW YORK, NEW YORK
Mr. DeRosa. I am John DeRosa, Managing Director and Global
Tax Director at Lehman Brothers. I appreciate the opportunity
to appear before the Subcommittee today on behalf of Lehman
Brothers.
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\1\ The prepared statement of Mr. DeRosa with an attachment appears
in the Appendix on page 80.
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Lehman Brothers, an innovator of global finance, serves the
financial needs of corporations, governments, municipalities,
and high-net-worth individuals worldwide. Founded in 1850,
Lehman Brothers maintains leadership positions in equity and
fixed-income sales, trading and research, investment banking,
private investment management, asset management, and private
equity. The firm is headquartered in New York, with regional
headquarters in London and Tokyo, and operates offices
worldwide.
As global tax director, I can state with confidence--and I
want to emphasize--that Lehman Brothers takes its obligations
under the U.S. tax code very seriously. Lehman Brothers has
worked diligently to follow the letter and spirit of the law
governing both equity swaps and stock loan agreements. The
rules governing the applicability of U.S. withholding tax for
payments made to non-U.S. counterparties on swap and stock loan
transactions referencing U.S. equities are clear.
Under Treasury Regulation Sec. 1-863-7(b)(1), the source of
notional principal contract income--i.e., swap payments--is
determined by reference to the residence of the taxpayer
receiving the payment, not the residence of the payor on the
underlying referenced asset. Thus, when Lehman Brothers makes a
payment on an equity swap referencing a U.S. asset to a non-
U.S. counterparty, the payment is sourced to the residence of
the swap counterparty and does not attract U.S. withholding
tax.
With respect to stock loans, IRS administrative Notice 97-
66 exempts from U.S. withholding tax in-lieu payments made to a
foreign counterparty when the criteria articulated in that
notice are met. Thus, under these rules, the transactions that
the Subcommittee is reviewing do not attract U.S. withholding
tax. When Lehman Brothers makes payments, whether pursuant to
an equity swap or a stock loan, to foreign counterparties
referencing U.S. equities, Lehman Brothers complies with these
rules. We understand that Treasury and the IRS may now be
considering whether these rules should be changed going
forward, including possibly advancing a new rule that would
recharacterize some, but not all, of these transactions. I can
assure you that, to the extent that Treasury or the IRS now
changes these rules, Lehman Brothers will comply with those new
rules.
Equity swaps and stock loan agreements are basic financial
instruments that have been in existence for decades and are
critical to the proper functioning of today's global capital
markets. There are many reasons--totally unrelated to
withholding tax--why clients use these instruments.
Fundamentally, clients employ these instruments to gain
economic exposure to underlying assets without beneficially
owning those assets. These instruments can provide clients with
leverage, operational and administrative efficiency, and other
balance sheet and regulatory capital benefits. In return,
Lehman Brothers receives financing spreads and commissions as
appropriate. These financial instruments, like many others such
as municipal bonds, offer tax efficiency in certain
circumstances--a result fully recognized by Treasury and the
IRS.
In fact, however, most of Lehman Brothers' equity swaps and
stock loans have nothing to do with U.S withholding tax
efficiency. The overwhelming majority of Lehman Brothers'
equity swaps and stock loans simply do not implicate U.S.
withholding taxes at all because they have one or more of the
following characteristics: One, the counterparty takes a short,
rather than a long, position; two, there is no distribution
payment on the underlying referenced security; three, the swap
or stock loan is not held by the counterparty over a dividend
record date; four, the underlying referenced security makes a
payment characterized for tax purposes as interest, which is
generally not subject to U.S. withholding tax; five, the
underlying security is foreign, rather than United States; or,
six, the counterparty is a resident in the United States.
It has been well understood for years that even when these
basic financial instruments do reference underlying U.S.
dividend-paying securities and are entered into as long
positions by non-U.S. counterparties over a dividend record
date--a relatively small universe of the transactions at Lehman
Brothers--they do not attract withholding tax under U.S. tax
laws. As I stated earlier, the basic rule for equity swaps,
established by Treasury in 1991, is that payments made to non-
U.S. counterparties pursuant to these basic financial
instruments must be sourced based on the residence of the
counterparty and, therefore, do not implicate U.S. withholding
taxes. In addition, an IRS administrative notice specifically
exempts from U.S. withholding taxes in-lieu payments on stock
loan transactions like the ones in which Lehman Brothers
participated. These fundamental rules--and the resulting tax
treatment for certain counterparties--have long been understood
by market participants and, notably, the Department of Treasury
and the IRS.
Indeed, most, if not all, of the major Wall Street
investment banks and commercial banks engage in equity swap and
stock loan transactions referencing U.S. underlying equities
with non-U.S. counterparties. Over the last 15 years, numerous
commentators in widely respected taxation journals have
addressed the withholding tax consequences of equity swaps
similar to those offered throughout Wall Street, including
articles by the current chief of staff for the Joint Committee
on Taxation and his former law firm. In 1998, a Notice of
Proposed Rulemaking was published in the Federal Register that
expressly addressed the same issue. It said, ``Treasury and the
IRS are aware that in order to avoid the tax imposed on U.S.
source dividends . . . some foreign investors use notional
principal contract transactions based on U.S. equities. . . .
Accordingly, Treasury and the IRS are considering whether rules
should be developed to preserve the withholding tax with
respect to such transactions.''
In May 2007, the Practicing Law Institute hosted a panel
focused specifically on the U.S. withholding tax aspects of
equity swaps and stock loan transactions. The panel included
well-recognized practitioners in the tax field including, most
notably, a representative from the IRS. Lehman Brothers has
provided the Subcommittee with a copy of that panel's
presentation.
Despite the IRS' clear recognition for at least a decade
that these financial instruments, in certain circumstances, may
have U.S. withholding tax implications, to date, no new rules
governing equity swaps or stock loan arrangements have been
promulgated. This is not surprising when one considers what a
fundamental change any such new rules would present,
particularly if those new rules were to articulate
circumstances warranting recharacterization of certain
transactions.
I should note, however, that even under existing law,
Lehman Brothers exercised appropriate care when entering into
financial instruments. Lehman Brothers consulted extensively
with tax experts both internally and at major Wall Street law
firms, receiving both oral and written advice. Based on the
advice of its legal counsel, Lehman Brothers put in place
guidelines and parameters governing the use of these
instruments. For example, Lehman Brothers instituted a minimum
duration requirement and established requirements governing the
size of underlying baskets. Under the prevailing rules
applicable to equity swaps and stock loans, transactions
meeting these guidelines should not be recharacterized for tax
purposes. In other words, according to the U.S. tax laws as
currently written, the payments made to non-U.S. counterparties
pursuant to equity swaps must be sourced to the residence of
the counterparty and, therefore, do not trigger U.S.
withholding taxes. Likewise, the type of in-lieu payments made
by Lehman Brothers on stock loans are specifically exempt from
withholding tax pursuant to the IRS administrative notice
mentioned earlier.
Lehman Brothers made every effort to ensure that its equity
swaps and stock loans complied with these guidelines. Indeed,
we know that in some situations clients approached Lehman
Brothers in an effort to transact in instruments in a way that
did not align with our product parameters--for example, by
seeking to hold a position for a very short period of time
around a dividend record date--and that Lehman Brothers refused
to engage in those transactions.
But Lehman Brothers did even more than that. In October
2007, when David Shapiro, Senior Counsel in the Treasury
Department's Office of Tax Policy, stated publicly that
Treasury would ``welcome input'' from the industry on the
proper tax treatment, Lehman Brothers responded. First, Lehman
Brothers participated with the Securities Industry and
Financial Markets Association to help develop a framework on
behalf of the industry. This analytical framework was shared
with Treasury and the IRS. Second, Lehman Brothers proactively
and independently engaged the Treasury Department in
constructive discussions explaining the equity swap business
and a possible new framework. These discussions culminated with
Lehman Brothers' submission earlier this year of a request to
the IRS, pursuant to the Industry Issue Resolution Program, for
official guidance. I have attached a copy of that submission to
my written testimony.
As I said at the outset, if new rules governing the tax
treatment of equity swaps and stock lending transactions are
promulgated, Lehman Brothers will comply with those new rules.
In the meantime, Lehman Brothers has made a concerted and good-
faith effort to comply with current tax law. We will continue
to do so.
Thank you again for the opportunity to appear here today. I
would be happy to answer any questions you may have.
Senator Levin. Thank you, Mr. DeRosa. Mr. Berke.
TESTIMONY OF MATTHEW BERKE,\1\ MANAGING DIRECTOR AND GLOBAL
HEAD OF EQUITY RISK MANAGEMENT, MORGAN STANLEY & CO., NEW YORK,
NEW YORK
Mr. Berke. Thank you, Senator. My name is Matt Berke, and I
am a Managing Director and Global Head of Equity Risk
Management for Morgan Stanley. Thank you for inviting Morgan
Stanley to participate in today's hearings. We have been
pleased to assist the Subcommittee's staff as it examined these
issues, and I hope that I have been a useful resource and will
continue to be today.
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\1\ The prepared statement of Mr. Berke appears in the Appendix on
page 88.
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I understand that the Subcommittee is focused on two
issues: Whether industry participants are complying with
applicable laws regarding dividend withholding obligations, and
whether new laws and policies may be appropriate. I cannot
speak for others, but Morgan Stanley believes that its
practices in these areas are in compliance with relevant tax
laws and regulations, and on the conservative end of the
spectrum. We have submitted a longer written statement for the
record, but I want to summarize a few key points now about our
equity derivatives and stock lending businesses.
Swap trading is widespread and commonly accepted in today's
financial markets, and Morgan Stanley is a leader in the equity
swap market. I understand that the Subcommittee is particularly
interested in a subset of the equity swap business, namely,
total return swaps with non-U.S. counterparties obtaining long
exposure to dividend-paying U.S. stocks. I will refer generally
to these as ``swaps'' or ``total return swaps'' in my comments
and in response to your questions. But I should be clear that
the swaps I am referring to constitute a small subset of Morgan
Stanley's overall global swaps business.
There are a variety of reasons why an investor may choose
to transact via swap, including leverage, operational
efficiency, and in some instances, tax benefits. I know from
talking with the Subcommittee staff members and from reading
the staff report that there is a great deal of focus on
business purpose and client motivation for these trades. Let me
start by saying our clients are, first and foremost, investors.
Their business purpose, their motivation when they transact, is
to put capital at risk in hopes of obtaining a positive
investment return. Only after making their threshold investment
decision of what to buy and what to sell do they begin to
confront the issue of the best means by which to put their
capital at risk, and tax can be an important part of that
decision.
Non-U.S. counterparties can choose to transact in swap in
part to reduce their tax obligations. This is a legitimate
choice and permissible under applicable tax laws, provided the
swaps are executed properly. We believe our swaps are properly
executed in compliance with relevant tax laws and regulations.
The relevant laws, as I understand them, provide that
payments made under swap contracts are treated differently than
dividends paid to owners of physical shares. That is the law,
and it reflects a decision made by policymakers. At Morgan
Stanley, our focus is on ensuring that what we offer to clients
as swaps are, in fact, swaps. And we do not enter into swaps
that could be recharacterized as repurchase agreements or
agency arrangements, which are subject to different U.S. tax
treatment.
To take a conservative position, Morgan Stanley has always
prohibited two-sided crosses to reestablish a physical long
position and currently prohibits swaps with crosses on either
end. We also do not allow our swap counterparties to direct our
hedge or tell us how or whether to vote any shares that we may
choose to purchase as part of a hedge.
I understand the Subcommittee is also interested in the tax
treatment of certain stock lending transactions. As one of the
world's leaders in equity financing services, Morgan Stanley is
active in borrowing and lending stocks both inside and outside
the United States.
One aspect of our stock loan business is an intermediation
business with Morgan Stanley standing between custodial lenders
and borrowers of U.S. dividend-paying stocks and earning a
spread between the cost of borrowing and the fees generated by
our on-lending activities. At Morgan Stanley, the stock loan
activity you have focused on is conducted by a desk in our
London office, focused largely on non-U.S. stocks but involving
some U.S. stocks as well. We believe we conduct this business
in compliance with IRS Notice 97-66, as we understand it, and
that our practices are on the conservative end of the spectrum.
Finally, I would like to say a word about tax policy in
general. The tax treatment of dividends generally differs from
the tax treatment of derivatives. Some have suggested a
comprehensive rethinking of how we tax capital investment
returns, regardless of whether the return is classified as a
dividend or not, and regardless of whether the investor is U.S.
or non-U.S. In light of today's hearings, additional guidance
on which investment structures the IRS would critique or
respect would be helpful, particularly for organizations like
Morgan Stanley, where we try to conduct our business on the
conservative end of the spectrum.
Thank you for the opportunity to testify, and I look
forward to your questions.
Senator Levin. Thank you, Mr. Berke. Ms. Leung.
TESTIMONY OF ANDREA LEUNG, GLOBAL HEAD OF SYNTHETIC EQUITY
FINANCE, DEUTSCHE BANK AG, NEW YORK, NEW YORK
Ms. Leung. Good morning, Chairman Levin and Members of the
Subcommittee. My name is Andrea Leung. I am the Global Head of
Synthetic Equity Finance for Deutsche Bank AG. I am based in
New York and have worked at Deutsche Bank since 2002.
Among my responsibilities is the management of the
synthetic equity desk in Deutsche Bank's New York office. Our
clients can use synthetic equity to replicate the economics of
a long or a short position in any particular equity security or
in a basket of securities. Specifically, we enter into
derivative or swap transactions with clients who want the
economics of purchasing or selling a single stock, a basket of
stocks, or an index of stocks without actually acquiring the
underlying securities.
Synthetic equity is a well-recognized, well-developed
financial product that has business purposes unrelated to
taxation in general or withholding taxes on dividends in
particular. Indeed, many of our clients manage ongoing
portfolios and execute trading strategies without owning any of
the underlying securities. All of their investments are held in
synthetic equity. Furthermore, we do transactions every day
with domestic U.S.-based entities. We use synthetic equity to
replicate short positions and to replicate positions in stocks
that do not pay dividends. This product was not devised and is
not held out by Deutsche Bank as a vehicle to avoid dividend
withholding taxes.
As my title Global Head of Synthetic Equity Finance
suggests, this New York business is a financing business. As
with any bank engaged in a financing business, we hope to
profit from spreads--here the difference between our own cost
of funds and that which we charge to the client. All clients,
whether they are large or small, long or short, onshore or
offshore, trading in dividend-paying securities or not, are
charged a fee based on Deutsche Bank's cost of funds plus our
cost of balance sheet usage, stock execution, and any risks
associated with the transaction, including the credit risk of
the counterparty.
We enter into swaps on all types of securities, including
convertible bonds. Our swaps business based on U.S. stocks
covers both dividend and non-paying dividend stocks.
Approximately 60 percent of our clients have long positions
with us, while the remaining 40 percent have short positions.
About one-third of our clients are based onshore, while the
remainder are based offshore. Our swap product allows clients
to execute trading strategies and take positions on U.S.
equities and equity markets without holding the underlying
physical securities.
Clients establish synthetic versus actual equity positions
for many reasons. Synthetic equity exposure, whether long or
short, is advantageous to clients as a financing technique.
Swaps provide clients with leverage, allowing them to gain the
economic benefit of purchasing and selling securities without
expending their own capital or having to pay the full cost of
trading such securities. Clients are relieved of having to pay
settlement costs and other back-office expenses. Also, because
swaps involve synthetic and not actual trading positions, swaps
shift from clients to the broker-dealers the obligation of
certain market trading rules, such as locates for short sales.
Synthetic position also allow clients to protect their
proprietary trading strategies from market competitors. Because
our synthetic equity product is intended to replicate the
economics of a position in the underlying security, we make or
receive payments under our swap agreements to give our clients
the financial equivalent of dividend payments. The same
economics could be replicated through a futures or option
transaction. I and my colleagues across Wall Street always have
understood that, as a matter of tax law, swap payments are not
subject to withholding tax, and the institution that makes them
is not a withholding agent. That remains my understanding.
Further, I have always understood that Deutsche Bank could
not be deemed a withholding agent unless its transactions with
customers were susceptible of being recharacterized as repo
transactions or stock loans.
We have taken a series of steps to eliminate any
possibility that our transactions could be recharacterized in a
manner that would violate tax laws or turn Deutsche Bank into a
withholding agent. We have done this in part by establishing
policies designed to prevent clients from entering swap
transactions close to a dividend event. Thus, our policies are
designed to encourage clients to hold for a minimum of 30 and
preferably 45 days.
In addition, we do not hedge our synthetic positions by
both buying and selling the underlying stock with our client.
We expect leverage to be a primary driver for entering into
synthetic positions, so we do not permit clients fully to
collateralize their positions. We also employ volume limits and
pricing policies to ensure that our hedging involves market
activity.
We believe our policy has worked and that our synthetic
equity business is not a tax dodge. The information we have
provided to the Subcommittee demonstrates that two-thirds of
all of our New York swap clients hold their swap positions at
least 60 days before dividend record dates, and two-thirds of
them hold their positions at least 60 days after dividend
record dates. Typically, our clients unwind their swap
positions not because dividends have just been paid, but
because their trading strategy dictates a change in investment
position. Further, we successfully market our synthetic equity
product to customers who want short positions and to customers
who want to enter into swaps on non-dividend-paying stocks.
The entirety of the business clearly supports our
understanding that our clients are entering into swaps for
sound business reasons and our transactions are entirely legal
under existing law.
Thank you for your time. I will do my best to answer any
questions that you may have. In the interest of time, I have
left out portions of my prepared statement, including those
addressed to the business conducted by my colleagues in London
and Jersey. With your permission, I will submit those portions
together with my written remarks for the record.
Senator Levin. Ms. Leung, you are reading a statement. You
have asked that the parts that you did not read be submitted to
the record. We asked you to provide a copy of that written
statement in advance, and you failed to do so. Why?
Ms. Leung. We were certainly trying to comply with
everything that you had requested and just as a matter of time,
did not have the chance to get that to you.
Senator Levin. You could not have gotten it to us this
morning? You could not have given it to us last night? Everyone
else gave us a copy of the written statements that they read
from.
Ms. Leung. I am sorry we did not do that.
Senator Levin. Mr. Berke, did Morgan Stanley market or
engage in swap or stock loan transactions principally for the
purpose of avoiding U.S. dividend withholding tax?
Mr. Berke. Senator, as I said in my opening remarks, we
believe the primary purpose of clients engaging in equity swaps
is to gain exposure to the underlying equity. Choosing swaps as
a means of gaining that exposure or choosing entering into a
stock loan is a secondary decision on their part on how to
potentially deal with issues, including taxes.
Senator Levin. Did you ever market your swap transactions
or stock loan transactions so your client could avoid U.S.
dividend withholding taxes?
Mr. Berke. We market the products generally and include
disclosure about all the relevant aspects of it, including any
tax implications or considerations that clients should have
when considering those investment opportunities.
Senator Levin. But did you ever market it focusing on
enhancing the dividend payout by not having to pay withholding?
Mr. Berke. Our marketing materials include a discussion
about taxes.
Senator Levin. Did this discussion ever tell your recipient
of your proposals that they would enhance the dividend payout?
Mr. Berke. Specific marketing materials may have, but
generally we do include----
Senator Levin. Take a look at Exhibit 26,\1\ would you?
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\1\ See Exhibit No. 26 which appears in the Appendix on page 256.
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Mr. Berke. I am familiar with this from preparation for
today's testimony.
Senator Levin. All right. This says, ``Here are the main
points regarding total return equity swaps on Microsoft why
offshore funds are subject to withholding tax of up to 30
percent on cash dividends from U.S. stocks. Morgan Stanley can
enhance the dividend payout from 70 percent to 100 percent
through a total return equity swap. This is a great opportunity
to highlight an application that is relevant to all dividend-
paying securities, not just Microsoft.''
Is that a Morgan Stanley document?
Mr. Berke. It is an internal distribution Morgan Stanley
document, so it is marketing to our internal sales people and
traders.
Senator Levin. And did those folks that were marketing this
particular type of a product use this argument?
Mr. Berke. They may very well have discussed these issues
as opposed to using this piece as a marketing piece, yes.
Senator Levin. But whether or not this particular piece was
used in marketing, is it fair to say that they would have used
this argument, this point in marketing for Morgan Stanley?
Mr. Berke. Yes, it is fair to say that.
Senator Levin. And so, therefore, is it not fair to say
that Morgan Stanley, when it was offering and suggesting total
return equity swaps to potential customers, used as an argument
that Morgan Stanley can enhance the dividend payout from 70
percent to 100 percent through a total return equity swap?
Mr. Berke. It is certainly the case in respect to the
Microsoft dividend, yes.
Senator Levin. Well, doesn't it say here ``not just
Microsoft''?
Mr. Berke. Yes, it does.
Senator Levin. Mr. DeRosa, did Lehman Brothers market or
engage in swap or stock loan transactions with the presentation
of the argument that your customer could avoid U.S. dividend
withholding tax?
Mr. DeRosa. Similar to Mr. Berke's answer----
Senator Levin. Give me your answer, if you would.
Mr. DeRosa. Fine. We included among the benefits from
entering into equity swaps the tax features.
Senator Levin. The tax features being?
Mr. DeRosa. Meaning the reduction of taxes payable.
Senator Levin. OK. Now, if you will look at Exhibit 22? \1\
This is a letter from you to Maverick Capital. Do you see on
page 2 it says, ``We have a variety of solutions using swap and
securities lending vehicles for achieving yield enhancement''?
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\1\ See Exhibit No. 22 which appears in the Appendix on page 242.
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Mr. DeRosa. I see that.
Senator Levin. Was that not clearly marketing to Maverick a
vehicle for increasing dividend yield, enhancing a dividend
yield? Is that not clearly what you were marketing there?
Mr. DeRosa. Among the other items listed in this letter,
yes, that was featured.
Senator Levin. And where are those other items?
Mr. DeRosa. In just looking down the list of starting at
the first page, it goes through several different aspects of
synthetic financing, I believe.
Senator Levin. Were any of those applying to your swap
product or your securities lending product?
Mr. DeRosa. I have not seen this document before this
morning, so I am just skimming it now. But I presume it is with
respect to all of the products that we offer.
Senator Levin. Well, why don't you read it now and tell me
whether any of those items on page 1 refer to your swap and
securities lending vehicle and whether you say anything about
your swaps and security lending vehicle except that it will
achieve yield enhancement. And then you propose that Maverick
provide Lehman Brothers with an interest list on a weekly basis
for possible enhancement trades. If that is not marketing a
vehicle to increase your dividend yield, I do not know what is.
Mr. DeRosa. Again, just looking at it for the first time,
at the bottom of the first page it is discussing our prime-plus
product; prime-plus provides U.S.-based hedge fund risk-based
margin lending.
Senator Levin. Right.
Mr. DeRosa. With all the benefits of traditional prime
brokerage, including insurance wrapper.
Senator Levin. Is that your swap lending to achieve yield
enhancement?
Mr. DeRosa. I am not sure exactly which product that is. I
apologize. But, again, what I am suggesting is that the letter
deals with other aspects that are advantageous to the client in
addition to the dividend enhancement.
Senator Levin. Well, you are selling a lot of things in
this letter. You are promoting a lot of things. One of the
things you are promoting is a swap and security lending vehicle
for achieving yield enhancement. Are you promoting it for
anything else other than achieving yield enhancement? Just take
a look at the paragraph. It says ``Dividend Enhancement
Solutions. We have a variety of solutions using swap and
securities lending vehicles for achieving yield enhancement.''
Do you list anything else there that you are using swap and
securities lending vehicles other than for that?
Mr. DeRosa. That paragraph does not. It references the
dividend enhancement feature associated with swaps and security
lending transactions.
Senator Levin. All right. Ms. Leung, did Deutsche Bank
engage in swap or stock loans transactions for the principal
purpose of avoiding U.S. dividend withholding tax?
Ms. Leung. We did not.
Senator Levin. All right. Now, take a look at Exhibit
31.\1\ On Exhibit 31, where it says, ``We are in the process of
determining hedge fund demand for `All In' enhancement to
clients for our proprietary trades,'' does that relate to
dividend enhancement?
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\1\ See Exhibit No. 31 which appears in the Appendix on page 265.
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Ms. Leung. This would relate to dividend enhancement.
However, I will note that we did not actually, to the best of
my knowledge, engage in any activity that came off of this
memo.
Senator Levin. So you determined there was no demand?
Ms. Leung. We determined that this was not something that
we wanted to market to our clients and actually discouraged any
marketing documents with regards to the Microsoft dividend.
Senator Levin. Did you hear Mr. Wolf on the prior panel
testify that Deutsche Bank marketed dividend enhancement swaps
to them? Did you hear him say that?
Ms. Leung. Yes, I did hear that.
Senator Levin. He was under oath.
Ms. Leung. Yes.
Senator Levin. You are under oath.
Ms. Leung. I understand.
Senator Levin. Do you disagree with him?
Ms. Leung. We market swaps to clients for a variety of
reasons----
Senator Levin. No. I am saying for dividend enhancement.
Ms. Leung. Dividend----
Senator Levin. That is what he testified to. Did you market
dividend enhancement swaps to them?
Ms. Leung. Sure, well, to----
Senator Levin. Pardon? The answer is ``sure,'' or your
answer is----
Ms. Leung. No. To address both of your questions
separately, first regarding this document, this is regarding
Microsoft, and in the case of Microsoft, we did not market the
Microsoft transaction. In fact, under our New York swaps desk,
we did a total of 500,000 shares worth of swaps during the time
of Microsoft, which is a very de minimis amount in the context
of our business, as well as had trading parameters around
making sure that there was investment intent with those trades.
With regards to selling our product and Mr. Wolf's comments
before, our swaps are marketed for a variety of reasons, for
counterparties who want long exposure and who want short
exposure, for those who have onshore and offshore entities, and
a variety of reasons including and most primarily leverage, as
well as protecting clients' market strategies and global market
access.
Senator Levin. Now, did Deutsche Bank market dividend
enhancement swaps----
Ms. Leung. We marketed----
Senator Levin [continuing]. For--all those other purposes
you just listed. But did you ever market swaps for dividend
enhancement?
Ms. Leung. We did market swaps with dividend enhancement as
part of one of the many other factors for doing swaps.
Senator Levin. Did you ever market swaps primarily for
dividend enhancement?
Ms. Leung. No, we did not.
Senator Levin. And so when Mr. Wolf said that Deutsche Bank
marketed dividend enhancement swaps to them, you are saying
that that was never the primary purpose that you marketed them
for?
Ms. Leung. To the best of my knowledge, yes.
Senator Levin. Would you have knowledge if you had done
that, if your firm had done that, if the bank had done that?
Would you be aware of it if Deutsche Bank did that?
Ms. Leung. Yes, I would be, and to the best of my
knowledge, we market swaps for many reasons, and----
Senator Levin. But never primarily for dividend
enhancement. Is that what you are telling us, under oath, that
your bank never marketed swaps primarily for dividend
enhancement. Is that what your testimony is?
Ms. Leung. We do not market swaps primarily for dividend
enhancement.
Senator Levin. And never have?
Ms. Leung. I can't speak to the lifetime of my firm.
Senator Levin. While you were there?
Ms. Leung. While I was there, correct.
Senator Levin. You never did that?
Ms. Leung. We did not--we did not market swaps primarily
for dividend enhancement.
Senator Levin. OK, good. And how long have you been there?
Ms. Leung. Since 2002.
Senator Levin. Thank you.
Mr. DeRosa, could you take a look at Exhibit 19? \1\
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\1\ See Exhibit No. 19 which appears in the Appendix on page 229.
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[Pause.]
Senator Levin. Are you familiar with this document?
Mr. DeRosa. Yes, I am.
Senator Levin. OK. Now, this is an internal review
document, as I understand it, a briefing paper that was devoted
to dividend enhancement and what the exposure would be of that
enhancement. Is that fair?
Mr. DeRosa. That is fair.
Senator Levin. And it lists Lehman Brothers' yield
enhancement product and has a chart estimating the amount of
dividends affected by each product, the amount of ``withholding
tax risk'' that the company thinks it might face if the IRS
rules against these products. It even has a description and
diagram of a stock loan transaction used for yield enhancement.
Now, is it fair to say that the reason that Lehman Brothers
prepared this document is in order to market yield enhancement
products and to look at what the potential risks would be of
that use in that market? Is that correct?
Mr. DeRosa. No. This document did not have to do with
marketing. This, as you indicated initially, was an internally
prepared document, shared internally, designed to assess the
different potential risks on the transactions.
Senator Levin. Of engaging in those transactions?
Mr. DeRosa. Correct.
Senator Levin. OK. So you were looking in some detail at
the exposure to you of these transactions. Is that correct?
Mr. DeRosa. The person who prepared this document, who was
not familiar in detail with all these businesses, was--with all
these products, rather, was trying to craft a high-level
assessment.
Senator Levin. Do you know who prepared this document?
Mr. DeRosa. Yes.
Senator Levin. Who was that?
Mr. DeRosa. Ian Maynard.
Senator Levin. OK. Why would you do this kind of an
analysis if you were not marketing these products?
Mr. DeRosa. What I think he was trying to give information
on was around Lehman Brothers' risk profile. Maybe I am missing
your use of the word ``marketing,'' but----
Senator Levin. You were engaged in these products, you were
involved in these products.
Mr. DeRosa. Correct.
Senator Levin. And your involvement was in products which
enhanced the yield of dividends. Is that correct?
Mr. DeRosa. Correct.
Senator Levin. Through the use of swaps.
Mr. DeRosa. And stock loans?
Senator Levin. And loans.
Mr. DeRosa. Correct.
Senator Levin. And so this was looking at what the risks
were of doing that?
Mr. DeRosa. Correct.
Senator Levin. But you were doing that despite these risks?
Mr. DeRosa. The risk was created due to the vacuum in which
we were operating as far as guidance is concerned, so at Lehman
Brothers, we measure the risk across all of our transactions,
and these are no exception. So what this document was
appreciative of is the fact that the IRS had indicated that
they might have a concern with the characterization of these
transactions, and, therefore, what we were trying to do here
was to create an indication of what the total maximum possible
could be, much like----
Senator Levin. What was that total maximum possible?
Mr. DeRosa. I am not sure what the total maximum was
because this document is fundamentally incorrect in assessing
the risk. What I can tell you is that the examination in which
we are involved by the IRS has generated a much smaller number.
Senator Levin. What is that number?
Mr. DeRosa. Roughly ten and a half million across the 2004-
05 period.
Senator Levin. What period?
Mr. DeRosa. For 2004 and 2005.
Senator Levin. And before that?
Mr. DeRosa. We did not measure that pursuant to the IRS
exam. The audit is restricted to those 2 years.
Senator Levin. And did you do any subsequent to that?
Mr. DeRosa. Subsequent to 2005, we have not taken the
detailed review, but we have done a fair amount of work around
2006 and 2007, and transactions that remotely, I think,
replicate the transaction as described in the Subcommittee
report probably generate several hundred thousand dollars of
dividends.
Senator Levin. OK. Take a look, if you would, Mr. DeRosa,
at Exhibit No. 12.\1\ This is an email from Mr. Demonte to
Elizabeth Black. They are both Lehman Brothers employees, as we
understand it. And here is what it says, that ``the spread
sheet contains long positions for Highbridge which we currently
buy into a swap to enhance their yield for dividends.'' Is that
accurate?
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\1\ See Exhibit No. 12 which appears in the Appendix on page 218.
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Mr. DeRosa. That is what it says.
Senator Levin. Are you familiar with this?
Mr. DeRosa. I have seen this document in my preparation.
Senator Levin. All right. So this spread sheet, then, looks
at Highbridge stocks which Lehman Brothers currently buys into
a swap to enhance their yield for dividends. That is the stated
purpose. Is that correct? There is no other purpose stated for
that swap except to enhance their yield for dividends. Is that
correct?
Mr. DeRosa. There is no other purpose stated in this email.
That is correct.
Senator Levin. And do you have any other document which
shows there was any other purpose for that particular swap?
Mr. DeRosa. I do not.
Senator Levin. OK. Could you take a look, if you would, Mr.
DeRosa, down at the page number at the bottom 33324.
Mr. DeRosa. Which tab?
Senator Levin. This is Exhibit 18.\2\ Now, if you take a
look at this exhibit, in the second paragraph--do you have it
in front of you now?
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\2\ See Exhibit No. 18 which appears in the Appendix on page 228.
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Mr. DeRosa. I do.
Senator Levin. It says that the CFD--and that is a swap
product--is usually used for yield enhancement purposes. And
that is a Lehman Brothers swap product, right?
Mr. DeRosa. CFD, yes.
Senator Levin. Is that Lehman Brothers?
Mr. DeRosa. CFD is a general term, not specifically Lehman
Brothers. But, yes, it is a Lehman Brothers product.
Senator Levin. But you are referring here to the Lehman
Brothers CFD, right?
Mr. DeRosa. I believe that is what he was referring to.
Senator Levin. Well, take a look at the previous paragraph.
It says the Lehman Brothers CFD, right?
Mr. DeRosa. Correct.
Senator Levin. OK. So we are talking about a Lehman
Brothers CFD and it is usually used for yield enhancement
purposes. Is that an accurate reading of your document?
Mr. DeRosa. That is an accurate reading.
Senator Levin. So you have this product, which is usually
used for yield enhancement. None of those other reasons are
specified. Is that correct?
Mr. DeRosa. You have got a salesperson drafting a document
here to one of his clients, and that is the purpose that he is
indicating in this document.
Senator Levin. Is he using any other purpose beside yield
enhancement in this document?
Mr. DeRosa. No, not in this document.
Senator Levin. So is that anything other than marketing
this particular product for yield enhancement purposes? What is
this other than marketing for yield enhancement purposes in
this situation?
Mr. DeRosa. I am not trying to debate the----
Senator Levin. Well, I am not trying to debate. I am trying
to get a straight answer from you. What other reason is given
in this document, and is this not a marketing document?
Mr. DeRosa. He gives no other reason in this document to
the person with whom he is communicating for doing the
transaction other than yield enhancement.
Senator Levin. And is it a marketing document, would you
not say?
Mr. DeRosa. I wouldn't necessarily call it a marketing
document, but that is fine. I don't object to that.
Senator Levin. Mr. Berke, take a look at Exhibit 27,\1\ if
you would.
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\1\ See Exhibit No. 27 which appears in the Appendix on page 259.
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This is an August 9, 2004, email from Daniel Brennan to
Alan Thomas, both Morgan Stanley employees. It says, ``Spoke
again''--are you with me.
Mr. Berke. Yes.
Senator Levin. Do you see where I am reading from?
Mr. Berke. Yes.
Senator Levin. ``Spoke again with Bill Scazzero who works
on Moore's,'' which is a hedge fund, ``trading desk, to
ascertain usefulness of the Microsoft total equity swap for
Moore Capital. Bill informed me that Morgan Stanley and Moore
Capital frequently transact such swaps to maximize returns
given offshore status and dividend withholding issues.''
Now, that is a Morgan Stanley document, right?
Mr. Berke. Yes.
Senator Levin. It is a contemporaneous document. Do you
have any reason to say that it is inaccurate, that there were
not frequent transactions using such swaps to maximize returns
given offshore status and dividend withholding issues? Do you
have any reason to say that is an inaccurate statement in
August 2004?
Mr. Berke. No.
Senator Levin. These are Morgan Stanley employees emailing
each other. Is that accurate? Daniel Brennan to Alan Thomas.
Mr. Berke. Yes, these are Morgan Stanley employees.
Senator Levin. All right. Mr. Berke, let me ask you about
your Cayman Islands operation. Do you employ folks in the
Caymans?
Mr. Berke. Not to my knowledge, no.
Senator Levin. If you will take a look at Exhibit 29.\1\
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\1\ See Exhibit No. 29 which appears in the Appendix on page 262.
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Mr. Berke. Yes, Senator.
Senator Levin. All right. Before I ask you specifically
about that document, in your opening statement, Mr. Berke, you
testified that between 2000 and 2007, Morgan Stanley Cayman and
Morgan Stanley International U.K. paid about $2.4 billion in
substitute dividends as a result of stock loans involving U.S.
dividend-paying securities. The Subcommittee understands that
about 49 percent, or $1.6 billion of that, was from your Cayman
Islands entity.
If U.S. withholding taxes on those dividends had been
collected at the 30-percent rate, the amount would total
approximately $300 million. However, no withholdings were
collected because Morgan Stanley took advantage of an IRS
notice and inserted a Cayman Islands shell company into this
transaction, and as a result, Morgan Stanley did not withhold
any of the dividend payments.
So far am I accurate?
Mr. Berke. Yes, by complying with IRS Notice 97-66----
Senator Levin. No, but is my statement, what I just read,
totally accurate in its total? Do you have any disagreement
with what I just read to you about your opening statement?
Mr. Berke. No.
Senator Levin. OK. Now, you said that you have no folks in
the Caymans, and now you are looking at Exhibit 29, which says
that Cayco--and Cayco is your company in the Caymans. Is that
correct?
Mr. Berke. Yes. It has a longer name, but we refer to it as
``Cayco.''
Senator Levin. OK. It is a thinly capitalized company,
cannot absorb losses, and it should never hold long stock
positions. Is that correct?
Mr. Berke. Yes, it is.
Senator Levin. It also says that it must not enter into
stock lending arrangements directly with MSIL. Who is that?
Mr. Berke. That is the former name of our U.K.-registered
broker-dealer.
Senator Levin. OK. Surplus cash in Cayco must not be lent
to any affiliate or entity in the United States without the
approval of the tax department. If it enters into derivative
transactions, dispensation should always be obtained from the
law and compliance department. It may not sell stock positions
to U.S. institutional investors. It may not enter into stock
lending transactions with any U.S. counterparties. It may not
purchase securities from any person in the United States. It
may not enter into derivative transactions with any U.S.
person. It may not carry out repo transactions with any U.S.
person. It may not source collateral from MS & Company. It may
not lend U.S. equities against cash collateral unless the cash
is equal to 200 percent. It may not carry out advisory
business. It may not invest in futures.
What can it do?
Mr. Berke. With respect to the United States, it primarily
engages in stock lending activity of U.S. stocks.
Senator Levin. All right. That was its purpose?
Mr. Berke. That is the primary purpose that I am aware of
that the vehicle is used for.
Senator Levin. Now, is it fair to say that is a shell
corporation, in common parlance?
Mr. Berke. That is a fair estimate, yes.
Senator Levin. Mr. DeRosa, Lehman Brothers has a Cayman
facility that it has used to run two stock loan transactions.
Does Lehman Brothers have people working in the Cayman Islands?
Mr. DeRosa. No, we do not. Just to clarify, the Cayman
Islands operation is a branch of our Hong Kong entity.
Senator Levin. That is Lehman Brothers' Hong Kong entity?
Mr. DeRosa. Correct.
Senator Levin. Can I call it Lehman Brothers without any
misunderstanding?
Mr. DeRosa. Sure.
Senator Levin. OK. Is that location in the Caymans still
used to transact stock loans involving U.S. dividend-paying
securities?
Mr. DeRosa. I believe it is.
Senator Levin. Ms. Leung, in 2004, Deutsche Bank Limited
began to use a facility in the Isle of Jersey to transact stock
loans using U.S. securities. According to an internal Deutsche
Bank application seeking approval for those transactions, the
reason for the proposed transaction and its location was so
Deutsche Bank could insert a ``non-U.S. treaty entity'' in its
stock loan transactions to avoid dividend withholding and lower
its stock loan pricing to match its competitors.
Is that the case, that Deutsche Bank set up this program in
the offshore jurisdiction of Jersey to exploit the IRS rule on
substitute payments and avoid the withholding tax on dividends,
thereby generating a bigger return on the transactions?
Ms. Leung. It is true that we started trading through our
Jersey entity. We did not feel that it was to exploit, but we
felt it was legal, perfectly legal under Notice 97-66.
Senator Levin. All right. To utilize that rule.
Ms. Leung. Yes.
Senator Levin. Except for that word--and I will say
``utilize'' instead of ``exploit''--was what I read to you
accurate?
Ms. Leung. Yes, it is accurate.
Senator Levin. Part of the desire to be more competitive,
to match its competitors, as I said, in order to match the
substitute dividend payments for stock loans and avoiding the
withholding tax on those substitute dividends to the extent
that your competitors were doing it. Is that correct? You
wanted to be competitive with your competitors in that area.
Ms. Leung. What we were trying to be competitive with was
on the ability to bid on pools of stocks available for lending.
We did not enter into any of these transactions with hedge
funds. The primary purpose of this in order to be competitive
with pricing was to tap into the pools of stock loan available
through institutions where, when bidding on those securities
and paying a fee to those institutions, a portion of those
securities would be U.S. securities. And under Notice 97-66, we
felt we could be more competitive in our pricing in order to
win those pools of securities.
Senator Levin. In order to be more competitive on your
pricing, you would, like your competitors, need to avoid the
withholding on those dividends. Is that correct?
Ms. Leung. We would need to not be subject to the 15-
percent withholding that we would have been subject to.
Senator Levin. And you used Notice 97-66 to avoid the
taxes. Is that correct?
Ms. Leung. We used Notice 97-66 because we felt that was
within the letter of the law.
Senator Levin. Right, and that would help you avoid those
taxes?
Ms. Leung. Notice 97-66 would keep us from being withheld
on those dividends.
Senator Levin. Ms. Leung, Deutsche Bank told the
Subcommittee staff that approximately 98 percent of the loans
transacted through the Deutsche Bank Jersey entity involve U.S.
dividend-paying securities. Are you aware of that?
Ms. Leung. I am not intimately familiar with it, but,
please, I will try to answer your question.
Senator Levin. Do you disagree with that?
Ms. Leung. No, I don't disagree.
Senator Levin. It also reported that in 2007 alone, DBIL
engaged in stock lending transactions involving U.S. dividend-
paying securities with a notional value of over $30 billion. We
have asked Deutsche Bank to supply us the amount of dividends
paid as a result of those $30 billion worth of loans, and when
are we going to get this information from you?
Ms. Leung. I have that information for you now. Again, if
these transactions were subject to withholding from the periods
2004 to 2007, that amount would be $27 million.
Senator Levin. OK. Would you submit to the Subcommittee the
way in which you reached that result? Not now, but would you
for the record submit to us your computations which led you to
the $27 million figure?\1\
---------------------------------------------------------------------------
\1\ Counsel to Deutsche Bank provided the Subcommittee with a
letter dated September 29, 2008, explaining that the $27 million figure
``was derived from an analysis of data reflecting stock lending
transactions and forward contract transactions involving the DBIL
entity . . . in which securities were held `for 21 days or less, where
such a time period covered a dividend record date of the securities[.]'
''
The Subcommittee advised Deutsche Bank that the request for the
approximate amount of total withholding taxes avoided through dividend
enhancement, yield enhancement, or other transactions that had the
reduction of withholding tax as a primary purpose was not limited to
transactions with a duration of 21 days or less. The Subcommittee asked
Deutsche Bank to provide the total amount of withholding taxes avoided
through transactions conducted through DBIL.
On October 30, 2008, counsel for Deutsche Bank responded with the
following information encompassing transactions from October 2004, when
DBIL commenced operations, through the end of 2007:
L ``[T]he total hypothetical estimated withholding figure for all
DBIL transactions of any tenor [is] $97,349,757.24. . . .
$27,819,148.73 of this total is due to transaction where a position was
held for 21 days or less. Another $8,479,821.51 is from transactions of
more than 21 days and fewer than 30 days. And the bulk of this total,
$61,050,787, is due to transactions where a position was held for 30
days or more. Deutsche Bank does not believe that a transaction where a
counterparty holds a position for a month or longer over a dividend
record date is one that necessarily `has as a primary purpose the
reduction, minimization, or elimination of withholding tax liability.'
''
---------------------------------------------------------------------------
Ms. Leung. Yes, we can do that.
Senator Levin. Ms. Leung, why did Deutsche Bank conduct its
stock loan business on U.S. securities with entities in 15-
percent tax jurisdictions from the Isle of Jersey?
Ms. Leung. I am not intimately familiar with that business,
but for these pools of--for these securities lending pools,
these were bids for international securities, and that was run
out of our London office.
Senator Levin. Was that to take advantage of Notice 97-66?
Ms. Leung. I do not believe----
Senator Levin. Was that utilizing that regulation?
Ms. Leung. It utilized the regulation, yes.
Senator Levin. All right. Let me ask you, Mr. DeRosa.
Lehman Brothers established tax risk limits for all of the swap
and stock loan transactions that you used for dividend
enhancement purposes, the Cayman stock loan transactions had a
$25 million annual limit, which was later raised to $50
million. Why did you set a tax risk limit?
Mr. DeRosa. It goes back to not having clear guidance
around the products.
Senator Levin. All right. Was that tax guidance from the
IRS, you mean?
Mr. DeRosa. Yes.
Senator Levin. And, Mr. Berke, did Morgan Stanley set any
tax risk limits on any dividend enhancement transactions
involving U.S. dividend-paying securities?
Mr. Berke. Yes, there is a risk limit on a type of equity
swap done out of London.
Senator Levin. That is it?
Mr. Berke. That is the only tax limit that I am aware of.
Senator Levin. And did Deutsche Bank have any tax risk
limits, Ms. Leung?
Ms. Leung. We did not have any risk limits.
Senator Levin. All right. And what about indemnity
agreements? First of all, Lehman Brothers, Mr. DeRosa, did you
have indemnity agreements?
Mr. DeRosa. My understanding is that there are standard
indemnity agreements found both in the ISDA contract governing
swaps and the OSLA contract governing securities lending. In
addition to that, when specifically asked by several clients
with respect to our stock lending activities, we did provide
further documentation, which basically provided more
specificity around the indemnification that is found in the
OSLA.
Senator Levin. Further documentation that had greater
specificity. Would that say that the customer wanted to be
clearer in terms of indemnity?
Mr. DeRosa. I think it does mean that the client wants more
guidance than the standard language that is found in the OSLA.
That is relatively broad. I think the wording is all
encompassing, but I think in certain instances clients would
like a more granular documentation.
Senator Levin. And would that granularity, speaking with
greater clarity, mean specific indemnity for substitute
payments?
Mr. DeRosa. The indemnity provides that the counterparty
would be not held liable if there were a withholding tax
imposed at a later date.
Senator Levin. On those substitute dividends?
Mr. DeRosa. Correct.
Senator Levin. Let's see. Did I ask you, Mr. Berke about
the indemnity?
Mr. Berke. Not yet. [Laughter.]
Senator Levin. I would not want to leave you out. Did you
issue indemnity agreements?
Mr. Berke. In connection with our Notice 97-66 business, we
have issued a handful of indemnities to order placers acting in
a fiduciary capacity on behalf of investment clients.
Senator Levin. Ms. Leung, did your bank issue indemnity
agreements?
Ms. Leung. We did not.
Senator Levin. OK. Finally, let me ask the three of you:
UBS has halted and Merrill Lynch has suspended stock loan
programs that use entities in offshore tax havens for the
purpose of utilizing that IRS notice. Do any of your companies
plan to take any similar type of action? Mr. DeRosa, do you
know of any plans by your company?
Mr. DeRosa. Not to the best of my knowledge.
Senator Levin. Mr. Berke.
Mr. Berke. Not to the best of my knowledge.
Senator Levin. Ms. Leung.
Ms. Leung. Not to the best of my knowledge.
Senator Levin. OK. Thank you for your appearance here
today, and I appreciate your testimony.
We are going to take a 5-minute break.
[Recess.]
Senator Levin. We will come back to order.
Let me welcome our final witness, Hon. Doug Shulman,
Commissioner of the IRS.
Commissioner Shulman, I want to thank you for being here. I
want to welcome you back to the Subcommittee. You have
testified before this Subcommittee before on tax haven banks
and U.S. tax compliance, and we very much appreciate your being
with us today. I know you are familiar with our rule that we
have to swear in all of our witnesses, and so I would ask you
to stand and please take the following oath: Do you solemnly
swear that all the testimony you will give before this
Subcommittee will be the truth, the whole truth, and nothing
but the truth, so help you, God?
Mr. Shulman. Yes.
Senator Levin. Thank you so much, and I think you know our
rule in terms of timing, and so we will just turn it right over
to you directly for your testimony.
TESTIMONY OF HON. DOUGLAS SHULMAN,\1\ COMMISSIONER, INTERNAL
REVENUE SERVICE, WASHINGTON, DC
Mr. Shulman. Thank you, Chairman Levin, and good morning. I
want to thank you for the opportunity to appear before you
today to discuss an issue of great interest both to the
Internal Revenue Service and this Subcommittee: The practice of
using certain financial instruments to reduce or eliminate the
U.S. withholding tax that applies to payments of dividends on
U.S. stocks to foreign persons.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Shulman appears in the Appendix
on page 94.
---------------------------------------------------------------------------
Let me reiterate what I told you previously: That I have
made international issues a top priority for the IRS during my
5-year term as Commissioner. I am only 5 months into that term,
but I am committed to aggressively pursue enforcement actions
where taxpayers use the complexities of international commerce
to circumvent their duties under the law.
I also want to tell you that I am personally focused on
these issues and am in the process of shifting more resources
to the financial markets in international arenas.
Let me also just reiterate the appreciation that I and
everyone at the IRS have for the support of the Members of this
Subcommittee and, commend you and your staff for your excellent
work. You really do great work, and it helps us out quite a bit
in doing our job.
In my limited time this morning, I would like to make a few
points about securities lending and equity swaps, and the
extent to which such transactions are being used as a means of
avoiding the withholding tax on dividends paid to foreign
persons.
Before going into my testimony, I must start by saying
that, as you know, taxpayer confidentiality laws preclude me
from disclosing information relating to specific taxpayers or
specific audits. Accordingly, I will not be able to comment or
respond to questions on any specific facts that have been
reported by the Subcommittee or other witnesses.
Our statutory and regulatory framework in this area, which
includes both legislation and administrative guidance, would
objectively be called ``a patchwork.'' Dividends in the cash
market are taxed at 30 percent, with a 30-percent withholding
tax. By contrast, capital gains earned by foreign persons on
these same stocks are generally exempt from U.S. tax by
statute. In addition, most forms of interest paid to foreign
persons are not subject to U.S. tax. And at the same time,
income earned by foreign residents with respect to total return
swaps are generally considered to be exempt from U.S. tax. With
that as a background and recognizing this patchwork, let me
connect the dots for the Subcommittee on the IRS's approach and
strategy in this area.
First, the IRS has numerous active investigations of the
types of transactions that we are discussing today. In these
types of large complex audits, our investigations lag behind
the tax years. For instance, the current examinations that we
have open generally focus on years 2004 to 2006, but we also
have investigations open in years before that. As you know, we
do not receive 2007 corporate tax returns until later this
month. However, if some of the type of information in your
report plays out as we look at current or later years, we would
have serious concerns and investigate the issues thoroughly.
Examinations in this area are extremely complex, often
involving multiple taxpayers, some of whom are foreign citizens
located outside the United States. As we discussed when I was
here before, when we have foreign citizens and entities outside
the United States, it can be harder for us to get there on our
investigative resources, and we talked about some potential
solutions like extending the statute of limitations.
In the course of our examinations, we have issued numerous
information document requests, requesting information related
to suspicious transactions. Depending on the nature of the
request, we look for emails, other documentation, and we also
take testimony. As I noted before, these are extremely complex
investigations, and they are still ongoing.
And while we are seeing some financial institutions whose
swaps and securities lending business is structured for bona
fide business purposes, we are also seeing some fact patterns
that are troubling. I cannot comment on the specifics of the
ongoing investigations, but I can tell you that where we see
transactions that we believe are abusive, under my tenure at
the IRS we will challenge them.
As I said before, the Subcommittee staff has done excellent
work in producing this report. There is one aspect of the
report, however, that is troubling to me. The report may leave
the reader with the impression that the IRS is reluctant to
challenge financial institutions on tax matters. The report
references the so-called Wall Street rule.
Let me state very plainly and unequivocally that where the
facts are favorable for the government, we will challenge sham
transactions that have no economic purpose other than tax
avoidance.
On the policy front, we are aware that some companies
believe there is a loophole in Notice 97-66 which allows them
to structure securities lending deals that avoid all
withholding on the payment of dividends. As you know, Notice
97-66 is 10 years old. I agree that Notice 97-66 should be
reviewed to determine if it can be modified in such a way as to
retain the original intent. I have asked the IRS staff to work
with the Treasury Department on this analysis.
As the Nation's tax administrator, I always welcome
dialogue on better ways to run our system of taxation. As we
look at this notice, however, we also have to recognize that it
opens broader economic policy issues, and we will need to
consider how it fits into our patchwork of taxation for the
capital markets.
Regardless, you should rest assured, Mr. Chairman, that on
my watch, the IRS will aggressively pursue financial
institutions who are using the complexity of the global capital
markets to avoid paying the taxes that they owe.
Thank you for the opportunity to appear today. I appreciate
the support that your Subcommittee has given the IRS over the
years, and I am happy to respond to questions.
Senator Levin. Thank you very much, Commissioner.
This has been going on for 10 years. You have only been
there, I guess, half a year--how many months have you been
there?
Mr. Shulman. Five months.
Senator Levin. Five months. We basically have heard for 10
years, not from you but from other folks at the IRS, that this
is troubling; they are reviewing particularly Notice 97-66.
Now, if you are sitting out there and you are a taxpayer in
this country and you are paying your taxes, including taxes on
dividends that you are receiving from companies, and then folks
overseas who are receiving dividends who are supposed to be
paying taxes on those dividends are using these gimmicks to
avoid paying taxes, and it was clearly not intended that they
be able to avoid paying taxes on dividends because we have a
withholding requirement--which has got teeth in it, but they
have avoided it through these gimmicks which you know about and
have heard about again this morning, why not just end it? I
know the policy arguments. Those policy arguments will rage
until someone resolves those policy arguments. And I take it
you have participated in policy discussions about this issue.
Is that a fair statement?
Mr. Shulman. Only very recently.
Senator Levin. Only very recently.
Mr. Shulman. Yes.
Senator Levin. But there are policy discussions which are
raging around this issue, I assume, within the IRS and in the
Treasury. Is that a fair statement?
Mr. Shulman. I think everyone is aware there are policy
issues.
Senator Levin. This hearing is not into the policy issues.
We will let the Finance Committee and others have that debate.
This is a question of enforcing our tax laws. They are not
being enforced. It is very simple. It is very clear. They are
not being enforced. We heard it here very clearly this morning.
They are clearly not being enforced on the stock loans, where
everyone acknowledges that that regulation was not intended to
allow for the avoidance of taxes when it comes to the stock
loans which we heard described. But then you have got these
phony stock sales that then are used as part of a swap
transaction to avoid the tax on dividends where swaps are used.
Now, why can't we just simply modify Notice 97-66? You have
acknowledged this morning its purpose is being obviated. I know
there are policy issues involved, but why not change the
regulation? It is acknowledged that its purpose is being
circumvented, so why not change it?
Mr. Shulman. You brought up a few things there. Let me
first say, if I were a financial institution testifying before
you, I would sit up here and be assertive and claim my view of
the tax law. I think the IRS may have a view that is different
from some of the things you have heard.
Senator Levin. Not on Notice 97-66.
Mr. Shulman. Well, second is we have a number of ongoing
investigations. On the spectrum of rules that are easy to
enforce or not, I would say Notice 97-66 happens to be one of
the more difficult ones, and that is why I acknowledge and
agree with you, and have asked the staff to start looking to
see if there is a way to modify it with the current Treasury.
And clearly, we are also going to have to have this discussion
with the next Administration.
But I do not think companies should take comfort, and I do
take issue with the notion that we are not being aggressive and
actively looking at these situations. As I said, we have open
investigations, some of which are in the years you have looked
at. All the things in this report are not things that are going
to go unnoticed. We are going to push on this very hard.
As you noted, I am 5 months into my term, and I think our
staff clearly understands that I think we should be aggressive
about this and make sure people are not circumventing the law.
Senator Levin. Well, you heard Professor Avi-Yonah say that
he heard a tax professional call these dividend enhancement
transactions an ``approved loophole.'' What is your reaction to
that?
Mr. Shulman. My reaction is for the current transactions
that are under investigation in the future, which are the ones
that I can influence on my watch. If I were a taxpayer, I
certainly would not take comfort that the IRS is not going to
challenge them.
Senator Levin. And you say that the so-called ``Wall Street
Rule'' that says if financial firms do certain transactions for
years, claim they are tax free, and the IRS does not object,
that the IRS loses the authority to challenge that transaction.
You challenge that rule?
Mr. Shulman. I do challenge that rule. I think there has
been no private letter rulings on this, which gets you a little
further down the road. Also, as we have talked about in other
hearings, I think you would agree that over the last 6 months
the IRS record of aggressively targeting international
transactions, taking a hard run at the QI program, and using
our John Doe summons authority, has shown improvement. These
are all things that had not been done before, and I think the
IRS is at least showing, since I have been here, an aggressive
stance. If I were a prudent taxpayer, I would not take comfort
in the notion of the Wall Street rule--that if we have not
looked at something before, we therefore think it is not within
the law, and will not look at it now or in the future. A
prudent taxpayer should not take comfort with that.
Senator Levin. Here is the testimony of Mr. DeRosa, which I
think you heard this morning: ``Most, if not all, of the major
Wall Street investment banks and commercial banks engage in
equity swap and stock loan transactions referencing U.S.
underlying equities with non-U.S. counterparties. Over the last
15 years, numerous commentators in widely respected taxation
journals have addressed the withholding tax consequences of
equity swaps similar to those offered throughout Wall Street,
including articles by the current chief of staff for the Joint
Committee on Taxation and his former law firm. In 1998, a
Notice of Proposed Rulemaking was published in the Federal
Register that expressly addressed the same issue. It said,
`Treasury and the IRS are aware that in order to avoid the tax
imposed on U.S. source dividends . . . some foreign investors
use notional principal contract transactions based on U.S.
equities . . . Accordingly, Treasury and the IRS are
considering whether rules should be developed to preserve the
withholding tax with respect to such transactions.' ''
Now, according to this testimony, that is 1998--so, in
other words, 10 years ago. So now the Treasury and the IRS have
been aware for 10 years because they said they were aware back
in 1998.
If you are aware of something for 10 years and do nothing
about it, why would you expect any other reaction on the part
of this business other than to just pile on, keep on using it,
keep on costing the Treasury and the IRS billions of dollars
over these 10 years? Why would you expect any other reaction
except that this is, in the words of the tax professional, an
``approved loophole''? Isn't that a kind of normal reaction
after 10 years?
Mr. Shulman. Well, I cannot speak to people's reactions.
What I can tell you is clearly, as I said before, some of the
testimony you heard today was people justifying transactions.
As you know, the tax code is four times as long as ``War and
Peace,'' and they picked out a nice sentence to give them
comfort, which might be false comfort.
We have a number of investigations underway. Some of the
stock lending under Notice 97-66 presents to us real questions
about the substance of the underlying corporation. In swaps, we
have investigations underway in the broadest terms on some of
the kinds of things you have looked at, crossing in, crossing
out only for tax avoidance purposes.
And so the notion that a lot of experts have opined on this
in the past, again, I would not, if I were a firm, take false
comfort in that. The IRS is looking at these issues and is
going to be aggressive.
Senator Levin. I am not talking about the number of
experts. I am talking about the Notice of Proposed Rulemaking
of the IRS. That is your own statement. This is an expert's--
not yours, the previous IRS Commissioner. ``Treasury and IRS
are aware that in order to avoid the tax imposed on U.S. source
dividends . . . some foreign investors use notional principal
contract transactions based on U.S. equities . . . Treasury and
the IRS are considering whether rules should be developed to
preserve the withholding tax with respect to such
transactions.'' Are you still considering it?
Mr. Shulman. Well, I think this is the swap----
Senator Levin. Yes. Are you consider it?
Mr. Shulman [continuing]. Issue that you are looking at?
Senator Levin. Right. Are you considering whether rules
should be developed to preserve the withholding tax with
respect to swap transactions that are used in the way we have
defined very specifically to avoid withholding? Is that under
consideration?
Mr. Shulman. I would tell you what you said earlier, that
certainly tax policy is not solely in the purview of the IRS
Commissioner. We are, however, actively investigating people
who use swaps potentially in ways that are only meant to avoid
the tax law, and do not really transfer benefits and burdens. I
just would not comment on broader swaps policy.
Senator Levin. And what is your policy about dividend
enhancement transactions?
Mr. Shulman. As you would agree, we do not have broad
policies. I think I, like you, find some of these marketing
materials distasteful. For us, though, as the administrator of
the law, we need to be fair and look at the rules and enforce
them.
So our concern is that when we see people exploiting the
tax law, not meeting the spirit and the letter of the law, not
meeting their tax obligations, we will go after them
aggressively.
Senator Levin. Are you able to put in writing what the IRS
position is about dividend enhancement transactions? Could you
issue just a statement as to what your position is?
Mr. Shulman. I am not----
Senator Levin. I think it will have a very salutary effect
if you could do that. First, on swaps, if you could do that, as
to when, from the IRS's perspective, is it appropriate that a
swap be used which involves a sale which is not a sale, which
then shifts the source. I think that it is reasonable for us to
know where you stand on that practice. And so I am going to ask
whether you would provide that for the country.
Mr. Shulman. Yes, I am not going to agree to write a
specific policy on dividend enhancements. I think we are pretty
clear that there is a current swap rule that has been in place
since 1991. With people who try to circumvent that rule, we are
going to be aggressive. We actually have ongoing investigations
that are complex and fact specific that I am not going to
jeopardize by going further and changing policy or discussing
that here, which is not clearly purely under my purview. I
think I owe it to the current and future Treasury Secretary to
have this discussion with them.
Senator Levin. I am not talking about whether the policy
should be changed. I am talking about what the current policy
is.
Mr. Shulman. Yes, I think the current policy on swaps is
this----
Senator Levin. Swaps when used in connection with these
phony sales in order to avoid taxes on dividends from non-
Americans. That is the issue.
Mr. Shulman. Oh, I think we have been pretty clear on that,
and I am happy to make sure we continue to be clear.
Senator Levin. If you could give us the clear statement for
the record, that would be very helpful.
Mr. Shulman. Here is what I am going to do. My biggest
concern is to make sure that we administer the law effectively,
and so I need to talk to the people who have ongoing
investigations and make sure anything we give you is not going
to endanger the government's position in the ongoing
investigation so that I can meet my promise of being aggressive
in this area to you.
Senator Levin. I accept that. We do not want to jeopardize
an investigation. But you said that the position of the IRS is
clear on that, and I would just like a copy of that clear
statement. OK? Is that fair enough?
Mr. Shulman. That is fair. I will give you as clear a
statement as I can get.\1\
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\1\ See Exhibit No. 36 which appears in the Appendix on page 304.
---------------------------------------------------------------------------
Senator Levin. Good. And then, second, on the Notice 97-66
regulation, since it is clear, I think everyone would agree,
that the Notice 97-66 regulation has been used in a way that it
was not intended, can you say that? And can you be that clear?
Mr. Shulman. I can tell you that certain financial
institutions have interpreted Notice 97-66 to mean that they do
not need to pay dividends if they structure a transaction a
certain way. I will also tell you what I said before about the
Wall Street rule, that people should not take comfort in the
notion that if we have not challenged transactions in the past,
we will never challenge them in the future. I can also commit
to you what I said before, that I, as IRS Commissioner who does
not have the sole authority to make broad policy changes, have
instructed our staff to start working with Treasury to review
this notice very closely.
Senator Levin. And can you state clearly what the intent
was of Notice 97-66 and what the intent was not?
Mr. Shulman. Well, first of all, I was not there when it
happened. But I will tell you what my understanding is. My
understanding is that it was intended to prevent cascading of
dividends, where there was a lot of confusion in the market
that multiple people were going to be paying tax on the
substitute dividends payments.
There was a notion that when the lending happened, it would
stay at the bank and the bank would pay the dividend, so that a
taxpayer would pay the tax on the dividend. I think the market
has gotten much more complex and much more sophisticated in
derivatives since then, and we potentially have unintended
consequences. But the original intent was to take care of the
cascading problem.
Senator Levin. And so it was intended that taxes be paid on
dividends.
Mr. Shulman. I cannot tell you that. What I can tell you is
that the original intent--the reason this notice was issued--
was to take care of the cascading problem.
Senator Levin. To avoid multiple tax.
Mr. Shulman. Yes. And, again, that was 10 years ago. I am
sitting here today, and you have my commitment to take a hard
look at this.
Senator Levin. And, finally, should we not under current
law treat dividend equivalent payments the same way we treat
dividends, as Professor Avi-Yonah recommends, under current
law?
Mr. Shulman. I think there are a whole bunch of ways to
structure synthetic transactions to avoid paying dividends on
economic structures that look pretty similar to a dividend
being paid. We have talked about swaps. We have talked about
securities lending. Equity-linked notes under statute, which
have nothing to do with IRS regulation, can be structured in
such a way that you can get money for dividends and a payment
for dividend and not pay the taxes on that same economics. So
what I would tell you is that this country does not have a
consistent approach to cash markets versus derivatives markets
and how to take them. That is a subject worthy of a broader
policy debate, and I think it would be relatively irresponsible
of me to lay down a stake on it now, since it involves a whole
bunch of other agencies and, clearly, the Congress.
Senator Levin. Thank you, Commissioner. I will just
conclude with this statement, that we are dealing here with
major financial players. They presumably do not want to be on
the wrong side of the law. If the IRS tells them to stop, they
would stop. So far, the IRS will not say ``Stop.'' It won't say
``Go.'' So the financial community does not really know if it
is on the wrong side of the law or not. Many of them claim
everyone is waiting for the IRS to make up its mind. After 10
years of mixed signals, the IRS' failure to say where it
stands, I think it makes a mockery of your mission. And we need
to have your resolution promptly. And if you cannot do it this
year, I hope you can do it by the spring of next year.
Is that a fair request?
Mr. Shulman. Yes.
Senator Levin. Thank you. We stand adjourned.
[Whereupon, at 12:23 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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