A recent article in the Wall Street Journal describes trading strategies implemented by US financial institutions and foreign hedge funds, aimed at reducing or eliminating withholding tax on corporate dividends paid overseas, and in some cases even creating fraudulent refunds from other jurisdictions for withholding taxes supposedly paid. The core of these strategies is simple: move the dividend paying stocks to lower tax jurisdictions when the dividends are paid, pay the original owner a fee equivalent to the dividend amount, then transfer them back once the transaction is complete. While this seems achingly simple, and thus easy to catch, the complexities of securities transfers between US and foreign entities, as well as the rules and regulations concerning international tax and securities transactions, were complicated enough to outrun the IRS for many years, earning huge fees for the firms and individuals formulating, marketing, and implementing these strategies. In fact, the main point of scrutiny still surrounding Bank of America, as indicated by the Wall Street Journal, was whether the profits earned were fairly paid to the actual owners of the underlying securities.
II. Overview of the Strategies Used
By implementing a variety of financial instruments such as equity swaps and stock loans, some US financial firms created transactions that would allow foreign clients to own stock in US corporations and receive the dividends without paying the applicable withholding tax. While these transactions varied in form, the essential purpose was to re-characterize a dividend as a swap payment, the latter of which requiring no withholding tax obligations.
As a bit of a background, stock swaps are exactly as they sound: an exchange of similarly valued stock in a corporation. These are typically done in the context of mergers & acquisitions, but occur in other situations such as the transactions at hand, described in more detail below. The matching of the securities for the purposes of swapping them is based on the swap ratio, which will reflect the overall value of the securities at hand. Alternatively, securities lending occurs when an investor borrows securities owned by another party and sells them for a profit. This is called short selling, and it occurs when the investor is aware that the stock price is going to drop. The investor borrows the security, typically with cash put up as collateral, sells the security when the price is high, and then buys it back at the lower price at a later time, essentially creating cash while ending up with the same property.
a. Stock Swaps
The ultimate goal behind using stock swaps to reduce tax withholding obligation on US dividends is to recast the character of a dividend as a swap payment, which won’t carry any withholding tax liability if qualified as a “dividend equivalent.” Treas. Reg. § 1.863-7(b)(1) states that the swap payment, or “notional principal contract” (NPC) income, is sourced based on the residence of the taxpayer at hand. This means that if the income from a swap transaction between a US entity and a foreign entity is paid to the foreign counterpart, it is deemed to be foreign source, and thus no US tax liability exists. However if the character of the income is deemed to be a dividend, the recipient would have a US tax liability under IRC §§ 871 or 881, and the payor of the dividend would have the obligation to withhold 30% under §§ 1441, 1442, and 1446.
It is this disparity that is taken advantage of in such transactions, where the exchange of the securities is made to look like a valid NPC, subject to zero tax, but in reality only exists to receive a dividend from the US without paying tax on it. While the actual transactions used are far more complex, the basic structure is as follows: a foreign person, typically an offshore hedge fund, owns an equity security issued by a publicly traded US corporation that will pay dividends on that security. The foreign person then sells this stock a few days before the scheduled dividend to a US financial institution, while at the same time entering into an NPC with the same US financial institution, the notional amount of the contract equaling the value of the stock. This temporarily replaces the foreign person’s stock holdings with the NPC, which is tied to the economic performance of the stock at hand.
The dividend is issued and received by the US financial institution, which then pays the foreign counterpart the dividend equivalent payment under the NPC, equal to the full amount of the dividend, less a fee for the transaction. Based on the US Senate’s Staff Report On Dividend Tax Abuse, the fee charged by the US financial institution is typically based upon the amount of tax savings that the foreign hedge fund will incur. The final result is that the hedge fund ultimately receives 92% to 97% of the dividend amount, instead of 70%, had the 30% withholding tax been taken out. A short time after the dividend is paid out, the NPC is typically terminated, and the security at hand is returned to the foreign entity.
The bending of the US dividend characterization and withholding rules are further exacerbated by the fact that many of these offshore hedge funds ended up being owned at the top level by US individuals. Many times the hedge funds had no physical presence in the foreign countries and were merely established as a fictional foreign presence in order to take advantage of these complexities in the tax code.
b. Stock Lending Transactions
In situations including stock lending transactions, which typically are used to make a profit through short selling, the stock is transferred between multiple parties in such a way where the timing of the dividend technically characterizes it as a dividend substitute. In this situation, a US financial institution uses an offshore corporation it owns to borrow US stock from a foreign hedge fund, a few days before the dividend is to be issued. The offshore controlled corporation then sells the stock to the US financial institution while at the same time entering into a swap transaction mentioned in the previous section, resulting in the stock being temporarily in the possession of the controlled foreign corp. The dividend is then issued, however because the swap transaction was initiated, the dividend is not characterized as such, and is therefore tax-free. The controlled foreign corp. then transfers that cash to the foreign hedge fund that ultimately owned the US stock, and a few days later transfers back the stock as well.
While technically different in nature, both the stock swap and stock lending strategies utilized by financial advisors relied on very specific terms in the US Code of Federal Regulations to reap huge rewards for their clients. The technical nature of whether or not these transactions had the requisite substance to be regarded as valid was not only highly complex, adding to the expense of challenging them, but the audit techniques and level of training required in order to spot and combat any rule breaking was that much more burdensome on a government agency such as the IRS. From this perspective it is clear just how much of a burden it is to enforce the ever-increasing complexity of preventing tax avoidance on an international scale. In an alternate universe where certain US taxes weren’t as burdensome to the taxpayer, perhaps so many individuals wouldn’t feel so compelled to escape the guise of the United States using these transactions, or other methods such as corporate inversions.
III. Current Regulations and Going Forward
As stated before, the general rule on US source dividends paid to a foreign person subjects these payments to a 30% withholding tax, unless an applicable treaty reduces that rate. In March of 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act, which added IRC § 871(m), designed specifically to counter dividend equivalent payments from escaping US withholding. Specifically, the code provision states that a dividend equivalent payment (including dividend substitute payments and any other similar payments as defined by the Secretary of the Treasury) is defined as a payment made pursuant to an NPC that is contingent on, or determined by reference to, the payments of a dividend from sources within the United States, and that these payments shall be sourced to the United States. The determination that these payments are automatically sourced to the US prevents the above-described transactions from escaping withholding by technically characterizing the payments as a different form other than a dividend.
Most recently in September of 2015, the Internal Revenue Service issued much anticipated final regulations to IRC § 871(m). These final regulations adopt certain concepts included in the proposed regulations to 871(m) that were issued in 2013. The test adopted from the proposed 2013 regulations is that of a “delta,” which is used to determine whether an instrument with payments referencing or deemed to reference US stocks was in the scope of § 871(m). The “delta” is a measure of the relationship between changes in value of the instrument and changes in value of the underlying stock. If the delta is 1, then changes in the value of both the stock and the derivative instrument are the same.
The reason for the delta test is that the level of dependency of the NPC upon the underlying stock that is transferred is determinative of whether or not the transaction at hand is likely created to fictionalize dividend-related payments. Much like in the previous section concerning stock swaps above, the notional value of the NPC issued regarding the stock swap was aligned with the value of the stock in order to essentially issue the same amount of cash as the dividend would have yielded to the foreign person. Thus, if the relational value, or delta, of the NPC is a certain threshold, then the payment will be deemed US source, and will impose an obligation to withhold.
Another provision that was proposed in 2013 and most recently adopted as final is the deemed combination of two transactions into one for purposes of the delta test, if the transactions were entered in connection with each other. In regards to the stock lending transactions discussed above, the party that borrows the security to short sell it would be under scrutiny as to whether its transactions are related. There is an exception to this however, where the shorting party is allowed to presume that two or more transactions are not related if (i) they are entered into two or more business days apart, or (ii) they are entered into in separate trading accounts. Despite this, the IRS still has the power to rebut this and deem multiple transactions as part of a segmented plan.