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Investigation of Lehman Tax Dodge Threatens Hedge Funds, Wall Street

Sept. 17, 2007 (EIRNS)—In a move which is causing seismic rumbling under the investment banks lining Wall Street, it has been discovered that the IRS is investigating a tax-dodge that could cost the "industry," specifically hedge funds, billions. Called "swaps," they are a means by which a fund can benefit (in the form of dividend payouts) from owning a stock, while not technically owning it, thus (in Wall Street-think) avoiding tax liability. The swaps, which now come in a myriad of subtle varieties, were originally the brain-child of Lehman Brothers Holding. The origin of these swaps, and their suspected illegality, is the subject of the lead article in Monday's Wall Street Journal.

According to the article, swaps were invented in 2004, in the wake of a $33 billion dividend payout by Microsoft Corp. Since large payouts like this are taxed at a higher rate, this meant that a big chunk of that payout would end up in the coffers of Uncle Sam (the IRS) in the form of taxes. Hedge funds don't like paying taxes. That is one of the major reasons the majority are registered in the Queen's dominion of the Cayman Islands. Wall Street had to find a solution.

Lehman's invention of the "stock swap" by which the offshore hedge fund doesn't actually buy the stock, but rather a derivative contract based on the stock's performance, was jumped on by the industry, with Citigroup and Merrill Lynch becoming leaders. But e-mails quoted by the Journal indicate that, even at its inception, the legality of the "swap" was in question. The IRS "should" consider them legal, according to an e-mail from an outside consultant. But even their original sales brochures promised clients "millions" in potential tax savings. They also worried about funds buying swaps for stocks which were expected to soon pay dividends, and then quickly selling them.

Swaps have become a normal part of hedge fund business practice. But, as economist and tax expert Joseph Stigliz noted for the Journal, the IRS will be asking "Would these trades occur at all if it were not for the tax advantages?" Since the answer is almost certainly "No," the IRS could hit traders with fines and bills for back taxes and penalties. The fact that the Wall Street Journal puts this on its front page, is a measure of the fear running through the board rooms at the reassertion of a sense of the General Welfare government regulatory agencies. It would signal a welcome blow against a parasitical industry which has run loose for too long.