DOJ Announces Victory in Foreign Tax Credit Trial

Manhattan U.S. Attorney Preet Bharara said: "The Court's decision rightly rejected an audacious tax-avoidance scheme that would have cost taxpayers hundreds of millions of dollars in lost revenue had it been allowed to go forward. Lehman moved millions of shares of stock around in an attempt to create tax credits available only under its questionable -- and, as the Court found, erroneous -- reading of a tax treaty, which it then tried to use to avoid paying taxes on its unrelated income."

According to the evidence presented at trial:

In the transaction at issue, LEHMAN's U.S. broker-dealer, Lehman Brothers Inc. ("LBI"), borrowed millions of shares of U.K. stock over their dividend record dates from U.S.-based lenders, and immediately lent them to its U.K. broker-dealer, Lehman Brothers International (Europe) plc ("LBIE"). LBIE, in turn, further lent the stock to a U.K. or European entity, or held the stock and used it for various purposes. Shortly after the dividend record date passed, the stock loans were unwound. Once the dividend was paid (to either LBIE or any entity to which it lent the stock), the recipient was contractually required to make a so-called "substitute payment" to the entity from which it borrowed the stock, in the amount of the dividend payment received. Thus, the ultimate holder would make a substitute payment to LBIE, LBIE would then make a substitute payment to LBI, and LBI would make a substitute payment back to the original lender. LBI, the U.S. taxpayer at issue, was accordingly just a pass-through entity between the ultimate stock lender and the ultimate stock borrower. LBI generally held the stock only for very short periods while shuttling it back and forth, and whenever it received a substitute dividend from LBIE, it paid out an equal substitute dividend to the original lender.

LEHMAN claimed that it was entitled to hundreds of millions of dollars' worth of FTCs as a result of these transactions under its reading of a provision of the then-prevailing U.S.-U.K. tax treaty. Lehman then purported to use the majority of the FTCs it claimed to offset taxes it owed on hundreds of millions of dollars of its unrelated income.

According to the treaty, U.S. recipients of U.K. dividends were potentially entitled to a U.S. FTC in connection with those dividends, but the "aggregate of the amount or value of the dividend and the amount of the tax credit . . . shall be treated as a dividend for United States tax credit purposes." The Government argued to the Court that the applicable U.S. tax credit rules prescribed certain conditions for when a taxpayer qualified for FTCs, among them that no credit would be given to a dividend recipient who acts as a middleman: in this case, someone who "is under an obligation . . . to make related payments with respect to positions in substantially similar or related property." Thus, the Government argued, LEHMAN did not qualify for the tax credit because LBI's obligation to pay out a substitute dividend was clearly "related" to its receipt of the substitute dividend from LBIE.

At the trial, the Court heard testimony from three former officials of the U.S. Department of Treasury who negotiated tax treaties, two who testified on behalf of LEHMAN, and one who testified on behalf of the Government. In the decision announced on Friday, the Court rejected LEHMAN's argument that the Court should ignore or read out of existence the treaty language requiring that the sum of the dividend and the U.K. tax credit "shall be treated as a dividend" for U.S. tax credit purposes. It characterized LEHMAN's arguments as impermissibly "cherry-picking" the treaty provisions that favor it -- such as the one that potentially allowed it to claim FTCs -- while rejecting the "shall be treated" provision that dooms LEHMAN's claim.

Mr. Bharara thanked the Internal Revenue Service Office of Associate Chief Counsel (International) and its staff attorneys for their work on the case.

The case is being handled by the Office's Tax and Bankruptcy Unit. Assistant United States Attorney Jean-David Barnea is in charge of the case.