Dividend arbitrage – a trading strategy undertaken by big banks to aid hedge funds and other clients in reducing taxes – has drawn criticism from U.S. authorities, per a Wall Street Journal report. The banks earn over $1 billion in revenues in a year through this strategy.
What is the Strategy?
The banks reduce the client’s tax by taking advantage of the differences in withholding tax rates in different countries.
Under dividend arbitrage, usually a bank enters into a stock swap, a derivative transaction with its client. In this transaction, the bank possesses the client’s shares of a different company at time when the client expects receipt of dividend. In turn, the bank moves the shares to its subsidiary or third party in a country where lower tax or even no taxes would pertain to the dividend. Thus, holder of the shares realize higher amount of dividend.
The related parties in the transaction – bank, its client and the holder of the shares – divide the amount of tax savings among themselves. Following the transaction, some clients may choose to take back their ownership of the shares.
Bank clients’ taxes on dividend payments gets lowered from 30% to 10% or even to zero through this strategy.
The Regulatory Concern
In 2008, dividend arbitrage came under the criticism of Senate investigators and gradually U.S. tax authorities took steps to address the issue. Owing to this, banks find it difficult to cut dividend taxes on U.S.-listed stocks. Currently, such a strategy largely operates from London and mostly involves European and Asian stocks.
While banks and hedge funds view the strategy as a legal one to trim down taxes, regulators are of a different opinion. Recently, Bank of America Corporation (BAC) has been questioned by the regulators “about potential legal and reputational risks from the maneuver”. The Wall Street Journal quoted a spokesperson for Federal Reserve Bank of Richmond. According to the spokesperson, BofA is addressing the concerns raised.
It is not yet clear whether other banks have faced related queries. Other banks that structure similar strategy include Citigroup Inc. (C), Deutsche Bank AG (DB), Morgan Stanley (MS) and The Goldman Sachs Group, Inc. (GS).
Notably, last week, the U.S. Treasury Department came up with new stricter rules on corporate "inversion" deals, to minimize the tax-avoidance transactions.
Bottom Line
As banks are already combating a number of challenges including a competitive environment, escalating costs and a persistent low environment, they are on a continuous look out for strategies to ease pressure on revenues. Addition of stricter regulation on this will further weigh on the business model of banks.
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