September 22, 2008
A key Senate investigative body has issued its latest findings in its investigation of alleged abusive tax practices, which is now in its seventh year. The investigation has examined alleged offshore tax havens, the way tax shelters are promoted, how assets are "hidden" offshore, and, most recently, dividend tax abuse. While it is not clear where the investigation will focus next, it is highly likely that it will continue.
On September 11, 2008, the Senate Permanent Subcommittee on Investigations issued a report alleging that large financial firms have facilitated the avoidance of U.S. taxes by offshore entities on dividends paid by U.S. corporations. The subcommittee, which is chaired by Carl M. Levin (D-Mich.), issued its report in connection with a hearing held September 11, 2008. Representatives of several Wall Street firms testified at the hearing, during which the subcommittee discussed six case studies of alleged abuse of the tax system. The subcommittee focused on two forms of transactions–equity swaps and stock loans–that allow non-U.S. entities to avoid withholding taxes on dividends paid from U.S. companies. This most recent hearing is the latest in a series of subcommittee investigations into large U.S. financial firms that offer tax savings to their offshore clients.
Recent Inquiries Conducted by the Permanent Subcommittee on Investigations
The Senate Permanent Subcommittee on Investigations, which has the broadest investigative mission in the Senate, has a history of investigating offshore tax abuses that dates back twenty-five years. Since 2001, the subcommittee has conducted six separate investigations into offshore tax havens. The subcommittee typically uses case studies to illustrate different types of alleged tax abuses and customarily calls upon its corporate and individual investigative targets to testify.
The subcommittee has focused both on entities that engage in alleged tax abuses and those who promote them. Earlier this year, the subcommittee’s staff issued a report criticizing firms for "using an armada of tax attorneys, accountants, bankers, brokers, corporate service providers, trust administrators, and others" to promote "tax havens to U.S. citizens as a means to avoid U.S. taxes."
Dividend Tax Abuse Investigation
The subcommittee’s most recent report singled out for criticism two types of transactions that allow foreign investors to avoid a withholding tax on U.S.-issued dividends that can be as much as 30% of the amount of the dividend. The subcommittee asserted that it has found "substantial evidence that U.S. financial institutions knowingly developed, marketed, and implemented a wide range of transactions" aimed at avoiding withholding taxes on dividends paid by U.S. corporations.
The first type of transaction is known as an "equity swap," whereby an offshore fund enters into a swap contract with a financial institution. The financial institution is obligated to pay the total return on the swapped stock, including any gains and dividends paid. But under a current IRS regulation, the total return swap payments are not subject to the withholding tax that would be due on dividend payments to foreign investors.
The second type of transaction highlighted by the subcommittee is a combination stock loan and swap arrangement between an offshore fund, an offshore subsidiary of a U.S. financial institution and the U.S. financial institution. Under this transaction, the U.S. corporation makes a total return swap payment to its offshore subsidiary which in turn makes a "substitute dividend" payment to the offshore fund. The parties to the arrangement take the position that the substitute dividend payment is not subject to withholding.
As Forbes noted after the hearing, the subcommittee’s main targets were the "investment banks that designed and marketed" these products, and "not the offshore investment vehicles that profited from them." Chairman Levin pointed to the companies’ internal emails, marketing documents, and promotional literature in alleging that the primary motivation behind these two products was purely tax avoidance. Firm representatives testifying at the hearing were asked to defend their marketing literature that promoted tax savings and to explain the non-tax benefits of equity swaps and stock loans.
What Firms Should Know
1. The Senate Permanent Subcommittee on Investigations is continuing its investigation of tax abuses that began seven years ago. The subcommittee is extremely aggressive in conducting its investigations and is not afraid to use its unusually broad subpoena authority.
2. This most recent phase of the subcommittee’s investigation was the end product of more than a dozen subpoenas and numerous interviews of bank executives, tax lawyers, and hedge fund managers. In all, the subcommittee compiled its report after reviewing hundreds of thousands of documents gleaned from the financial firms being investigated.
3. The subcommittee is pressuring the IRS and the Treasury Department to increase their enforcement actions and to revise notices and interpretations of the tax code in order to eliminate offshore dividend tax avoidance.
4. Firms subject to the subcommittee’s investigative power can be expected to account for marketing literature, internal communications, and other documents that promote tax savings, as well as to explain the non-tax benefits of financial products offered to clients. They also should anticipate being called as witnesses at a subcommittee hearing.
5. Firms under investigation should have a clear understanding of the differences between Congressional and other government investigations and should adjust their defense strategies accordingly. One key difference involves the mechanisms used to enforce requests for documents, other information, and testimony. These must be understood in order to make informed decisions on how to respond to Congressional committees.
 Senate Permanent Subcommittee on Investigations, Staff Report, "Tax Haven Banks and U.S. Tax Compliance," July 17, 2008, p. 17, available at http://hsgac.senate.gov/public/_files/071708PSIReport.pdf.
 The September 11 report issued by the Subcommittee on Permanent Investigations, "Dividend Tax Abuse: How Offshore Entities Dodges Taxes on U.S. Stock Dividends," is available online at http://levin.senate.gov/newsroom/supporting/2008/091108DividendTaxAbuse.pdf.
 Anita Raghavan, "The Tax-Dodge Derivative," Forbes.com, Sept. 11, 2008, available at http://www.forbes.com/businessinthebeltway/2008/09/11/senate-dividends-tax-biz-beltway-cx_ar_0911divtax.html.
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