Were Some Derivatives Trades Primarily About Tax Avoidance?

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.

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  1. leftcoast

    Time to scrap the Federal Income Tax and subsitute the Automated Payment Transaction Tax proposed by a University of Wisconsin Econonmics professor several years ago.

  2. dd

    As anyone who has followed the saga of LTCM knows, it’s all about tax avoidance. The district court opinion is a great read especially the Scholes/Stiglitz smackdown @78-86 http://www.usdoj.gov/tax/082704JBALongTermUS.pdf
    Long Term Capital Holdings v. United States, 330 F. Supp.2d 122, 199 (D. Conn. 2004), aff’d 2005 U.S. App. LEXIS …

  3. Anonymous

    Were Some Derivatives Trades Primarily About Tax Avoidance? Of course. Dividend arbitrage has been going on for at least 20 years. It’s good to see the IRS ahead of the game…

    C’mon, if company A has low tax on a dividend and company B has high tax, there are all kinds of derivatives that A and B can trade where both make money. If that’s not economic, what is? A sells a call, B buys the call. Using its tax rate, company B thinks the implicit vol is x; using its tax rate, company A thinks the implicit vol is x + something. Then A turns around and buys a put from someone, and B sells a put. Now both A and B have pretty close to a riskless position and a sure profit, all thanks to the taxman who has devised arbitrable rules.

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