Senate Report Finds Financial Institutions Used Swap Transactions to Help Offshore Hedge Funds Avoid Taxation of Stock Dividends

A Senate report has detailed how some financial institutions designed and implemented swap transactions and stock loans to enable offshore hedge funds to dodge millions of dollars of taxes on U.S. stock dividends each year. The scheme took advantage of ambiguities in federal tax law and pushed the tax-avoidance envelope aggressively. The report identified offshore hedge funds as frequent participants in the abusive dividend tax transactions, which were facilitated by their U.S. general partners or investment managers. The report found that many of the offshore hedge funds’ main offices were in the United States, as well as their key decision makers and investment professionals. Their offshore presence often was nothing more than a Cayman Islands post office box.

The Senate staff assured that they are not condemning the legitimate use of complex financial transactions that utilize stock swaps or stock loans. Rather, the Senate is targeting abusive financial transactions that have no business purpose other than tax avoidance. The report recommends measures to stop the misuse of structured finance to undermine the federal tax code.

Foreign investors are exempt from many U.S. taxes, such as capital gains, but if they invest in a U.S. company and the stock pays a dividend, U.S. law requires the foreign investor to pay a tax on the dividend. Right now, under the federal tax code, while U.S. stock dividends paid to non-U.S. persons are generally subject to a 30% tax rate, dividend equivalents paid to non-U.S. persons as part of a swap agreement are not subject to
any U.S. tax at all. The abusive stock swap tax transactions took advantage of this disparity in tax treatment.

The Senate report urges Congress to end offshore dividend tax abuse by enacting legislation clarifying that non-U.S. persons cannot avoid U.S. dividend taxes by using a swap or stock loan to disguise dividend payments. This legislation should end the abuse by eliminating the different tax rules for U.S. stock dividends, dividend equivalent payments, and dividend substitute payments, making them all equally taxable as dividends.

The Senate also wants the IRS to complete its review of dividend-related transactions and take civil enforcement action against taxpayers and U.S. financial institutions that knowingly participated in abusive transactions aimed at dodging U.S. taxes on stock dividends. The IRS is also urged to stop the misuse of equity swap transactions to dodge U.S. dividend taxes by issuing a regulation to make dividend equivalent payments under equity swap transactions taxable to the same extent as U.S. stock dividends.

To stop misuse of stock loan transactions to dodge U.S. dividend taxes, continued the report, the IRS should issue a new regulation on the tax treatment of substitute dividend payments between foreign parties to clarify that inserting an offshore entity into a stock loan transaction does not eliminate U.S. tax withholding obligations

According to Senator Carl Levin, chair of the subcommittee that produced the report, hedge funds and other offshore entities could not perform their dividend tax escape act without the assistance of financial institutions that devise the abusive transactions and send the U.S. dividend payments offshore to their clients in the form of dividend equivalent or substitute dividend payments, without remitting any taxes to the U.S. Treasury.

Under the abusive swap transaction detailed in the report, the financial institution promises to pay the hedge fund an amount equal to any price appreciation in the stock price and the amount of any dividend paid during the term of the swap. The payment reflecting the dividend is a dividend equivalent. In return, the hedge fund agrees to pay the financial institution an amount equal to any price depreciation in the stock price. The financial institution hedges its risk by holding the physical shares of stock that were “sold” to it by the hedge fund. It also charges a fee, which usually includes a portion of the tax savings that the hedge fund will obtain by dodging the withholding tax.

The swap gives the hedge fund the same economic risks and rewards that it had when it owned the physical shares of the stock but, under the tax code, dividend payments are taxed while dividend equivalent payments made under a swap are not. Under IRS regulations, when a financial institution makes a dividend equivalent payment to an offshore client under a swap agreement the tax code provides that the payment is from an offshore source and free of any U.S. tax. According to Sen. Levin, that approach turns the usual meaning of the word ``source’’ on its head because, instead of looking to the origin of the payment to determine its source, the IRS swap rules look to its end point of who received it.