SwarmPoint

After any serious hurt there is a call for immediate action in the political sphere. People look to politicians to protect them, and politicians are happy to encourage the notion. This rush to action overlooks the fact that even the management of the investment banks hadn’t understood the situation in time to avert their own losses. They are all very capable, highly functioning individuals but were unable to play out the head game of managing the risks effectively. There is little reason to think that regulators are better able to understand the issues and we have seen that the regulators both in the US at the SEC and in the UK with Northern Rock have failed to understand the pending emergency or to act. This does not prove incompetence but primarily points to the misplaced expectation that they would be able to.

There are more modest and specific areas which can be codified such restricting the scale of bond insurance / credit default swaps (CDS) for a given level of reserve. This would in reality restrict this market to a fraction of its prior scale but would make bond insurance a realistic private business. CDS contracts are not independent events and market slumps inevitably result in failures of those over selling insurance via CDS contracts. The staggering number and value of these contracts, given the level of reserves of the companies writing them, mean they are not enforceable as written and do not really have the value described without recourse to government bail outs.

The scapegoat of short trading is a cosmetic political issue similar to restricting profit taking on building supplies during a Florida storm. Its main purpose is to avoid news stories and resentment and its main effect is to reduce the motivation to assist in running an effectively priced market. People don’t like to hear that anybody has profited from a downturn but this can’t be confused with addressing the causes of the bad news.

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Finance, Securities Lending financing, regulation

The Senate permanent subcommittee on investigations has published a press release about a report which appears not to be available online.

This relates to the common practice of trying to lawfully minimize ones taxes by investing in ways which are subject to lower tax rates. A normal business practice. Unfortunately the committee is representing this as tax dodging and maligning the industry.

Many countries offer lower dividend tax rates to one type of entity than another. In some countries to encourage inward investment and in some situations to benefit local investors. In some cases the benefit is just that the tax is not withheld from the dividend and instead becomes a tax liability which is assessed in the normal taxation cycle. In many cases, particularly with cross border investment somebody holds stock via a preferred entity in order to more efficiently manage their taxes. For example via a locally registered entity or an offshore entity or via an insurance company. It has also been common practice for at least the last fifteen years to arrange swaps or loans of securities which occur only during the dividend season in order to have better control of the securities settlement during the rest of the year and still have the dividend benefits. In such cases the fee for the transaction accounts for the fact that there will be a dividend benefit.

In many cases the tax benefit is the primary reason for such transactions but to try to prevent the securities from flowing to lower tax entities is an attempt to stop water flowing down hill. To some extent these noises from polititions are a signalling arrangement where the industry becomes more or less cautious about the type of transactions it performs. For the financial services industry, both brokers and clients, there is a significant risk of suddenly receiving a tax liability that had not been factored into the original transaction. In practice the IRS can not be in the middle of every transaction and relies upon such signalling. We can have rules about what structures are permitted but they need to be clear. Most tax advice is after all aimed at minimizing tax liability. Still there does need to be caution not to start carelessly prosecuting those who have allowed water to flow down hill on their land.

A better solution than those suggested is to have clear and more even tax rules regardless of entity so that there is less reason to add the overhead of administering these transactions. That requires harmonization both internally and internationally given the diverse listings of securities in the modern world. That of course in turn requires hard work for politicians, co-operating across borders and doesn’t allow for drama of the more visceral press releases.

According to the press release, in the report, the Subcommittee Majority staff recommends the following:

1. End Offshore Dividend Tax Abuse. Congress should end offshore dividend tax abuse by enacting legislation to make it clear 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, and making them all equally taxable as dividends.
2. Take Enforcement Action. The IRS should 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.
3. Strengthen Regulation on Equity Swaps. To stop misuse of equity swap transactions to dodge U.S. dividend taxes, the IRS should issue a new regulation to make dividend equivalent payments under equity swap transactions taxable to the same extent as U.S. stock dividends.
4. Strengthen Stock Loan Regulation. To stop misuse of stock loan transactions to dodge U.S. dividend taxes, the IRS should immediately meet its 1997 commitment to issue a new regulation on the tax treatment of substitute dividend payments between foreign parties to make clear that inserting an offshore entity into a stock loan transaction does not eliminate U.S. tax withholding obligations.

There are reports of the press release in the New York Times and the FT with little reaction.

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Finance, Securities Lending irs, lending, Securities Lending, swaps, withholding