Does anyone on Wall Street have any sense? If you are designing transactions that are solely or primarily about tax avoidance, you don’t leave a mile-wide paper trail, particularly documents with titles like “Tax Efficiency” for the IRS to find. From “IRS Probes Tax Goal of Derivatives” in the Wall Street Journal:
Federal tax authorities are seeking data from two large U.S. financial firms to determine whether complex derivatives trades they engineered for hedge-fund and other clients were designed primarily to avoid taxes, people familiar with the matter say.
Banking giant Citigroup Inc. and Wall Street firm Lehman Brothers Holdings Inc. have received information document requests, or so-called IDRs, from the Internal Revenue Service relating to the use of derivatives by offshore investors, including some big hedge funds, to sidestep withholding taxes on U.S. stock dividends, these people say. Many U.S. hedge funds have offshore hubs.
At issue 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 doesn’t hold the stock.
The question for the IRS: Are these trades executed for an economic purpose, or solely to evade taxes?
The IRS requests come as Wall Street braces for a broader inquiry into a practice that is common among some securities firms, which for years have pitched clients on these transactions using names such as “Yield Enhancement,” “Dividend Arbitrage” and “Tax Efficiency” trades.
At stake is more than $1 billion in withholding taxes on U.S. stock dividends that are sidestepped by derivatives trades structured by a number of Wall Street firms, accountants say.