A U.S. Senate committee probe has found that several major Wall Street firms helped offshore hedge funds dodge millions in U.S. taxes with complex derivative and stock-loan transactions.

The Permanent Subcommittee on Investigations said that Merrill Lynch, Morgan Stanley, Lehman Brothers Holdings and UBS, among others, designed products to get around a law requiring them to withhold taxes on stock dividends paid to offshore investors. The probe also found that the Internal Revenue Service turned a blind eye to the practice.

According to the subcommittee, the banks, which also include Citigroup and Deutsche Bank, created products with no legitimate purpose other than helping clients avoid the 30% dividend taxes. Some of the so-called “dividend-enhancement” products allowed offshore funds to sell their shares in dividend-paying companies to the investment banks, while simultaneously entering into a swap contract that paid the banks a fee in exchange for the equivalent of the dividend and any investment gains.

The investigation found that such deals saved Lehman Brothers clients some $115 million in taxes in 2004 alone. The numbers for Morgan Stanley clients are $300 million saved from 2000 through 2007. The products earned Morgan Stanley $25 million in 2004, UBS $5 million in 2004 and Deutsche Bank $4 million in 2007.

Sen. Carl Levin (D-Mich.), who heads the subcommittee, says he plans to push the IRS to get the money it is owed, and potentially seek penalties against the banks and the hedge funds. He is also considering a bill to make it harder to create dividend-enhancement products for the sole purpose of avoiding taxes.

“We are going to press the IRS to go after what is obviously a scheme,” Levin said. “The IRS should be going after this. They are not. They have been pussyfooting around this.”