Sex abuse has so dominated the headlines of late that I was beginning to miss stories about tax abuse. But tax abuse aficionados now have something to chatter about thanks to the justifiably obscure Permanent Subcommittee on Investigations of the U.S. Senate’s Committee on Homeland Security and Governmental Affairs (“PSIHSGA”). Apparently for political effect, PSIHSGA Chair Carl Levin timed for September 11, 2008 this shocking (not) exposé on dividend abuse.
Whenever a legislative subcommittee’s name includes the word “permanent,” we should expect it’s staff to work overtime to justify their organizational existence. The PSIHSGA is no exception.
In this context, it is a matter of curiosity why, on the anniversary on the 9-11 attacks on New York, a subcommittee of the Committee on Homeland Security & Governmental Affairs should make a stink over an arcane international tax artifact manifestly beyond its expertise and squarely within the jurisdiction (and competence) of the Senate Finance and House Ways and Means committees. Are U.S. borders really so secure that PSIHSGA can think of nothing more pressing to investigate?
Setting aside the absurdity of its involvement in the tax arena, what did the PSIHSGA say yesterday? Answer: not much worth remembering except as an illustration of how an arrogant, out-of-touch Congress fritters away valuable time and resources in pursuit of political theater.
I have read the Staff Report for the hearing and statements by IRS Commissioner Shulman and John Derosa, Global Tax Director for Lehman Brothers. My sense is that Senator Levin wanted attention and, most likely, congressional Democrats wanted a chance to publicly beat up another Wall Street whipping boy just before the November elections. Makes for good material on the stump: “Send me back to Congress to fight those selfish, tax-cheating bankers!”
It is a fundamental rule of U.S. tax law that, with respect to their non-business income, non-residents pay U.S. tax only on their U.S.-source income as this term is defined by the Internal Revenue Code and Treasury Regulations.
For legitimate reasons long-recognized by the Treasury Department and congressional committees with tax expertise, dividend-like income from certain derivative financial instruments — principally equity swaps — is “sourced” by Treas. Reg. § 1.863-7(b)(1) to the recipient’s country of residence. Therefore, it is not subject to U.S. tax when received by non-residents. Hence, Senator Levin and company — who know just enough about taxes to be dangerous — pitched a fit.
As John Derosa pointed out, these derivative instruments have been used for legitimate business purposes for decades:
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. . .
. . . 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.
Levin’s committee staff were unable to accurately estimate how much revenue the IRS loses each year through this so-called loophole, but they tried to make it sound as earthshaking as possible. Meanwhile, Commissioner Shulman — who was obviously on top of the issue long before Levin’s people got involved — tried to respectfully discourage hasty regulatory action:
Whether to adopt further [regulation] necessitates a careful consideration of the possible ancillary effects . . . We must be careful as we look at potential changes in the regulations to ensure that we are driving the proper type of behavior while not impeding legitimate business transactions. This may mean that we have to make difficult choices because changing regulations to address one problem may raise critical issues in another area.
More broadly, we must make sure that any changes do not have unintended consequences.
No truer words have ever been spoken by any regulator in any age of the Republic.
If Levin’s committee really wants to save federal tax dollars, might I suggest an investigation of Senator Levin and his congressional colleagues who annually steal billions in the form of pork-barrel earmarks for silly pet projects back home. What are the chances?