[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 

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        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.
---------------------------------------------------------------------------
    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.''
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Potapchuk appears in the Appendix 
on page 70.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Wolf appears in the Appendix on 
page 75.
---------------------------------------------------------------------------
    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?
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 7 which appears in the Appendix on page 203.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 27 which appears in the Appendix on page 259.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 29 which appears in the Appendix on page 262.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.]


























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