Citigroup, Lehman Receive IRS Requests: WSJ

U.S. tax authorities are seeking information from two U.S. banks to determine whether complex derivatives trades they undertook for clients, including hedge funds, were designed primarily to avoid taxes, the Wall Street Journal reported in its online edition on Thursday.

Citigroup and Lehman Brothers have received information document requests, so-called IDRs, from the Internal Revenue Service relating to the use of derivatives by offshore investors who may have sidestepped withholding taxes on U.S. stock dividends, the paper reported, citing people familiar with the matter.

At issue, the Journal said, are derivatives trades where securities firms buy stocks from offshore hedge-fund clients, and in return pay them the return of the stocks and any dividends they generate.

If a $10 stock rises to $11 and pays a dividend of 15 cents, the securities firm pays the hedge fund $1.15, representing the appreciation and the dividend, minus a small fee. The trade could save the hedge fund from paying as much as 30% in taxes on the dividend, depending on the venue, because the fund technically does not hold the stock, the Journal said.

The IRS is probing whether the trades were made for economic reasons, or solely to avoid taxation.

The IRS requests come as lawmakers scrutinize the tax advantages of some of America's wealthiest firms, including private equity and hedge fund firms. It also comes as Wall Street braces for a broader review of practices common among some trading firms which for years have pitched clients on transactions with names such as "Yield Enhancement," "Dividend Arbitrage" and "Tax Efficiency" trades, according to the report.

At stake in the derivatives probe is more than $1 billion in withholding taxes on U.S. stock dividends that are sidestepped by the specialized trades structured by a number of Wall Street firms, the Journal reported, citing accountants.

Neither Lehman Brothers or Citigroup could immediately be reached for comment.