Auction rate securities and diminishing account sheet numbers aren't the only problems haranguing Wall Street majors.

According to a report released today by a US Senate committee investigation, several of them are apparently involved in an elaborate scheme of tax evasion.

Lehman Brothers Holdings Inc., UBS AG and Merrill Lynch & Co. are among Wall Street firms that concocted derivatives and stock-loan deals to help offshore hedge funds dodge hundreds of millions of dollars in US taxes, according to the report by the US Senate Homeland Security subcommittee on permanent investigations.

Of course, Swiss institution UBS, the world's largest wealth manager, is not exactly a stranger to such charges of tax evasion. In fact, investigations into its questionable activities had caused it to shut down its offshore banking business for US clients.
(See: UBS under US investigation for tax evasion; senior executive detained and UBS exits offshore business in US)

The report said investment bankers use phrases like "dividend enhancement," "yield enhancement" and "dividend uplift" to market an array of transactions "whose major purpose is to enable non-US persons to dodge payment of US taxes on stock dividends."

According to Democratic Senator Carl Levin, who chaired the committee, the Internal Revenue Service (IRS) looked the other way while securities firms sold complicated financial products designed to skirt a law requiring them to withhold US taxes on stock dividends paid to offshore investors. He said he wants the IRS to pursue back taxes or penalties against Wall Street firms and their hedge-fund clients that got around a 30 per cent dividend tax.

''We are going to press the IRS to go after what is obviously a scheme,'' Levin said, while briefing reporters yesterday about the committee's yearlong probe. ''The IRS should be going after this. They are not. They have been pussyfooting around this.''

The committee estimates that using offshore entities to avoid paying US taxes costs the federal treasury about $100 billion annually. The report did not put a specific amount on tax losses due to stock swaps and loans transactions with offshore entities, but said the amount is "substantial."

The IRS is scheduled to testify before the subcommittee at a public hearing today. The report provided case studies of transactions by six financial institutions: Lehman Brothers Holdings Inc, Morgan Stanley, Deutsche Bank AG, UBS AG, Merrill Lynch & Co Inc and Citigroup Inc.

Representatives of Lehman Brothers, Morgan Stanley and Deutsche Bank are due to testify today. Representatives of hedge fund managers Maverick Capital Ltd, Highbridge Capital Management LLC, and Angelo, Gordon & Co are also set to testify.

Levin said transactions aimed at avoiding US dividend taxes have become widespread in the offshore hedge fund industry and that some of the funds function as shell companies controlled by Americans.

"It adds insult to injury when so-called 'offshore' hedge funds turn out to have a shell operation offshore and their real headquarters are in the United States with US personnel advising them on how to dodge US taxes," said Levin.

Morgan Stanley's dividend-enhancement products generated $25 million of revenue for the company in 2004 alone, and cost the US government more than $300 million in unpaid taxes from 2000 through 2007, the report said.

Lehman Brothers, in an internal document described in the Senate report, estimated that it helped clients avoid $115 million in taxes in 2004. Dividend-enhancement transactions earned about $5 million of profit for UBS in 2005, and $4 million for Deutsche Bank in 2007, the report said.

The report recommended that the US Congress enact legislation to make it clear that foreign investors cannot avoid US dividend taxes by using a swap or stock loan to disguise dividend payments. It also encouraged the IRS to take tough enforcement action against transactions that have no economic purpose other than to avoid taxes.

The report also recommended IRS tighten its rules to make sure that dividend equivalent payments made in an equity swap transaction are taxable just like direct dividend payments to investors.