September 17, 2007

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HAPPY RETURNS
How Lehman Sold Plan
To Sidestep Tax Man

Wall Street firms have long sought to use financial alchemy to save clients a bundle on their tax bills. Now, one of the Street's cleverest strategies is coming under scrutiny.

The strategy arose a few years ago, a time when lots of U.S. companies were paying fat dividends. Wall Street sensed a golden business opportunity: sell their hedge-fund clients on ways to make those dividends even fatter by avoiding taxes on them.

Bankers at Lehman Brothers Holdings Inc. pitched an enticing product. By using a complex financial tool called derivatives, hedge funds with offshore operations could reap the benefits of owning big-dividend U.S. stocks without actually owning them. The result: no dividend-tax bite. Different versions of the strategy cropped up all over Wall Street.

Hedge funds were thrilled. The Internal Revenue Service apparently wasn't. Federal tax authorities are seeking information about the trades from Lehman and Citigroup Inc., The Wall Street Journal reported in July, and other firms are bracing for similar inquiries. The government's question: Are the trades executed for any purpose other than to sidestep the dividend tax?

A look at the evolution inside Lehman of this controversial tax product shows that the firm paid considerable attention to how the IRS might react. Internal Lehman emails reviewed by the Journal reveal bankers searching for the line between smart tax planning and improper tax avoidance. In the end, according to the emails and to people familiar with Lehman's business, the bankers and their lawyers concluded that it was a business worth pursuing.

In recent years, Wall Street firms have been devising increasingly complex ways for sophisticated investors like hedge funds to minimize their tax bills. That's made it tough on tax authorities charged with deciding which maneuvers comply with tax laws and which don't.

The dividend-tax trades represent one more dimension to the spread of derivatives, complex financial instruments whose values are tied to those of assets such as stocks, commodities or currencies. Investors first turned to derivatives to hedge against risk, then as a tool to add leverage. Now, Wall Street is marketing them as a way to minimize taxes. This comes at a time when Congress is considering changing the way hedge-fund managers and private-equity firms are taxed.

The dividend-tax trades have allowed hedge funds to avoid paying more than $1 billion a year in taxes on U.S. stock dividends, accountants and others in the business estimate. If the IRS decides the tax treatment of the trades isn't proper, it could try to slap funds with big bills for back taxes.

Nobel laureate Joseph Stiglitz, a Columbia University professor and expert witness in tax cases who examined some of the Lehman documents, says the question for tax authorities is: "Would these trades occur at all if it were not for the tax advantages?" If the answer is no, he says, "at the very minimum, it is a red flag."

Nearly every major U.S. securities firm -- from Lehman to Citigroup to Merrill Lynch & Co. -- offers such derivatives to hedge-fund clients. Foreign banks such as Germany's Deutsche Bank AG and Switzerland's UBS AG also sell the products, people familiar with the business say.

Some bankers contend that U.S. tax rules on dividends don't apply to derivatives because derivatives aren't governed by the same rules as stocks. "We believe we are in line with industry practice as articulated by major law firms in accordance with the full knowledge of the IRS for many years," says John Wickham, whose job at Lehman includes overseeing the group that sells these types of derivatives. Citigroup says that the IRS views the inquiry as industrywide, and that it is cooperating. Merrill, Deutsche Bank and UBS declined to comment.

Wall Street has devised many forms of dividend-tax trades, of varying complexity. One simple kind uses a derivative called a stock swap. A Wall Street firm buys a block of stock from a hedge fund. The investment bank and the hedge fund also agree to an exchange: For a stipulated period of time, the investment bank makes payments to the hedge fund equal to the total returns on the purchased stock -- the dividends plus the share appreciation -- thereby simulating the benefits of actually owning the stock. In return, the hedge fund makes payments to the bank tied usually to a benchmark interest rate. If the stock declines in value, the hedge fund also must pay the bank the equivalent of the lost value.

Ordinarily, the IRS, to ensure it can collect dividend taxes from hedge funds that own U.S. stock but are domiciled outside of the country, requires securities firms to withhold the taxes from dividend payments distributed to the funds. (Domestic taxpayers are required simply to declare dividend income on their U.S. tax returns.) But when an offshore fund enters into a stock swap, who's on the hook for the dividend taxes? The U.S. banks that peddle such swaps are responsible for paying the tax, but they offset the dividend income with the expense of swap payments made to the hedge funds. The result: Because the payments received from the hedge fund are comparatively small, the bank has very little taxable income. The swap payments received by the offshore hedge fund are not subject to U.S. taxation.

The IRS declines to comment on the matter.

Hedge funds use swaps for all sorts of reasons having nothing to do with tax planning, including to lower trading costs and to make it harder for rivals to figure out what they're investing in.

The dividend-tax trading strategy became popular after changes to federal tax laws in 2003, which lowered the tax rate that individuals pay on dividends, but left the corporate rate intact. Many companies then boosted their dividend payments. European hedge funds and U.S. funds with offshore hubs jumped into these U.S. stocks, but were looking for ways to lower the tax bite.

For years, many securities firms in London, including Lehman's office there, had used derivatives to help hedge funds avoid paying a British tax known as the stamp duty, which is levied on purchases of stocks and real estate. In the summer of 2003, Richard Story, a Lehman executive in London, began pressing managers in New York to boost the volume of dividend-related derivative trades they executed, according to people familiar with the matter.

Lehman had concocted a strategy it called the Cayman Islands Trade, which offered offshore hedge funds -- including the many U.S. funds with offshore operations -- a way to "enhance the yield" on dividend-paying U.S. stocks, according to a Lehman document. The trade, which involves several legs, originates with a loan of stock from a client to a Lehman entity in the Cayman Islands.

To ascertain whether tax products will pass muster with federal tax authorities, U.S. securities firms routinely seek opinions from in-house and outside lawyers. Some legal opinions conclude that products "will" pass muster, while others say they "should." Both grades are considered to provide acceptable legal comfort. "More likely than not," a lower grade, is seen as more problematic.

"I know you got US Tax Dept (Darryl) comfortable on the Cayman yield enh. [enhancement] trades after a lot of gentle persuasion," Mr. Story wrote in a June 12, 2003, internal email, referring to Lehman tax attorney Darryl Steinberg. "Did we finally get a written opinion from external counsel and if so what level of opinion was it...?"

The view from outside, at least initially, appeared fuzzy. A lawyer from Cravath, Swaine & Moore LLP initially believed the transactions "should" pass muster with the IRS, according to an email to Mr. Story from Bruce Brier, a Lehman senior vice president. But after a talk with a Lehman tax lawyer, the Cravath attorney "downgraded his opinion to 'more likely than not,'" Mr. Brier wrote in the email. "I think I can get him back to 'should.'"

A Cravath spokeswoman declined to comment, as did Mr. Steinberg. Mr. Story, who no longer works at Lehman, didn't respond to requests for comment.

"You are looking at a one-page personal opinion in a thousand-page universe," a Lehman spokeswoman says. Mr. Brier's email "in no way suggests that Cravath provided an actual written opinion and then changed it. Rather, it appears Mr. Brier and Corporate Tax were separately discussing the Cravath lawyer's possible opinion level considering a variety of different factors, some of which, when combined, would lead to a 'should' level and others a 'more likely than not.'" Such an exchange is "an ordinary process of idea sharing."

Lehman touted such trades to clients in a brochure entitled "The Power of Synthetics." The derivatives would transfer to clients "economic exposure of a security, basket or index without taking physical ownership or delivery," the brochure said. The potential benefits included "tax management" and "yield enhancement," it said.

A Lehman document indicates that a number of hedge funds entered into trades, including Angelo Gordon & Co.; Highbridge Capital Management, the big hedge fund majority-controlled by J.P. Morgan Chase & Co.; JMG Triton; and KBC Alternative Investment Management. The Lehman document projects that the trades would save Highbridge, which has about $37 billion in assets, about $10.8 million in withholding taxes in 2005. JMG Triton was projected to save $15.3 million, Angelo Gordon, $9 million, and KBC, $3 million, according to the document.

A KBC spokesman says, "We have not seen that document and do not know what those numbers represent. The only reason we would track withholding taxes is if they are owed." Highbridge declined to comment. Angelo Gordon and JMG Triton didn't respond to requests for comment.

Lehman and its clients saved $70 million in taxes they potentially owed in 2004 because of the swaps, according to the Lehman document, which refers to the withholding-tax savings as "WHT@Risk." Lehman says the figure is from a "draft presentation" and only represents "one person's view of hypothetical exposure," which the firm now calls unrealistic. People familiar with Lehman's operations estimate that over the past 3½ years, the firm has saved about $200 million for its clients through such tax trades. A Lehman spokeswoman calls the figure "conjecture."

In 2004, after Microsoft Corp. set plans to pay a one-time dividend of $3 a share -- a $33 billion total payout -- competition heated up among Wall Street firms to offer clients ways to capture a greater after-tax share of the dividend. Ian Maynard, a Lehman trading manager based in London, saw the special dividend as an opportunity for Lehman to seize business from competitors. But Lehman rivals were more aggressive, offering clients as much as 97% of the Microsoft dividend amount compared with Lehman's 95%, according to people familiar with the matter.

Some aspects of the business, including its profitability, worried Mr. Maynard, these people say. In a Sept. 21, 2004, email to several Lehman executives, he suggested Lehman was taking too much risk by "guaranteeing" to pay the entire dividend amount to clients through some derivative trades. The range of clients for whom Lehman is "guaranteeing 100%" has "increased significantly," he wrote.

In the email, he also noted that there appeared to be no "consistent" standards about the minimum time clients held the derivatives, and that "churning" -- a term commonly used to refer to excessive short-term trading -- appears to be "reasonably frequent." From a tax-risk perspective, that was important. If it appeared that clients were executing such trades before dividend time, then unwinding them just after dividends were paid, tax authorities could suspect the trades were done solely to avoid taxes.

"We need to set minimum holding periods following advice from tax/compliance and eradicate any frequent churning of position," Mr. Maynard wrote.

Mr. Maynard referred questions about the matter to Lehman's spokeswoman. "In light of evolving market conditions and technological advances," she says, "Ian wanted to make sure that we were consistently enforcing the policies we had put in place."

Some at Lehman expressed concern over swaps tied to a single stock. Mr. Brier, the senior vice president and a tax lawyer by background, was worried the single-stock swaps could be viewed purely as a maneuver to sidestep withholding taxes, say people familiar with the situation. In an email early in 2005, he questioned whether such swaps, from a taxation standpoint, were essentially stock loans. It was a crucial question: When stocks are lent across borders, the dividend payments can be subject to taxes.

John DeRosa, Lehman's top tax official, says swaps "possess markedly different fundamental and economic characteristics from stock loans" and thus are not subject to withholding taxes.

In a Feb. 14, 2005, email to Mr. Brier and others, Neil Sherman, a Lehman sales executive, suggested some guidelines for single-stock swaps, including that clients be required to hold them for at least 30 days. Swaps that give clients exposure to a basket of stocks could be used, he wrote, but "care should be taken, through the observation of objective criteria, that such swaps do not have withholding tax avoidance as a principal purpose."

In a return email, Mr. Brier told Mr. Sherman it would be "premature" to issue any new single-stock swap guidelines because, among other things, there hadn't been approval from the firm's tax department.

The Lehman spokeswoman says the directive by Mr. Sherman, who is no longer at the firm, was not triggered by any problem. Mr. Brier said recently, in a prepared statement: "It has since come to my attention that the firm had appropriate policies in place since 2000 regarding single-equity swaps, and had previously taken legal advice from numerous outside law firms that addressed the issues which I was raising and had reached similar positive conclusions....After many discussions internally and with outside counsel, it was my belief that the product was legally sound and appropriate."

At a meeting last fall of the Wall Street Tax Association, a group of tax experts, Lehman and other Wall Street firms got their first inkling that tax authorities were examining dividend-related trades, people familiar with the meeting say. Directors were buzzing about rumors of an IRS inquiry into such trades, these people say.

Todd Tuckner, UBS's tax head for the Americas, indicated that the IRS had given the bank a diagram of a transaction it appeared to be scrutinizing, the people say. After checking with the IRS, Mr. Tuckner made the diagram available to the group. Mr. Tuckner, through a spokesman, declined to comment.

Lehman still offers single-stock swaps to clients. "Because there has been no definitive guidance to the financial community on this issue, Lehman, like its competitors, relies on its own internal analysis of the tax law and a 'should'-level tax opinion from a major Wall Street law firm that clearly distinguishes our single-stock-swap trades from stock loans," the firm says. It declines to say which law firm provided the tax opinion.

Write to Anita Raghavan at anita.raghavan@wsj.com¹