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Senate threatens IRS derivatives crackdown

September 12th, 2008 Leave a comment Go to comments

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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