From the desk of Roy Zimmerhansl
Practice Lead, Pierpoint Financial Consulting
As readers of my last blog may recall, I did my first stock loan in 1981, so I’ve seen and heard a lot. For a long time, the words “dividend arbitrage” were used in hushed whispers in dark corners, dressed up on occasion as “yield enhancement” attempting to ride the coattails of other investment strategies to give it an air of legitimacy. My argument has always been that reducing tax liabilities within the letter and the spirit of the law is a normal business practice, so why muddy the waters? Nevertheless, for better or worse, this is an example of the legacy lack of transparency for the business that I suggest persists today.
For years, many people have often (incorrectly) assumed that stock on loan over a dividend period is being used for dividend arbitrage. I recall reading an article last year entitled “The Return of Dividend Arbitrage” referencing activity in stocks that were, in fact, nothing to do with taxation of dividends, instead were scrip dividend trades. However, as they took place around dividend time, the author assumed they must be dividend arbitrage. Such assumptions are easily made and understandable. (Note to readers: as part of his series on trading strategies, my colleague Jeroen Bakker will focus on scrip dividends in a future blog post.)
EBA Report into dividend arbitrage trading schemes
This week, the European Banking Authority (EBA) produced its report into dividend arbitrage schemes. The process started at the request of the European Parliament in 2018 which asked ESMA and EBA to conduct an inquiry into dividend arbitrage schemes. The EBA press release highlights three critical takeaways from the report.
The EBA’s inquiry showed that national authorities do not share the same understanding of dividend arbitrage trading schemes, due to differences in Member States’ domestic tax law;
The inquiry concluded that facilitating, or handling proceeds from tax crimes undermines the integrity of the EU’s financial system and, therefore, sets out a number [of] expectations of credit institutions and national authorities under the current regulatory framework;
The EBA decided on a 10-point action plan for 2020/21 to enhance the future framework of prudential and anti-money laundering requirements covering such schemes.
If I summarise the EBA report as a schoolteacher might, the assessment for the National Competent Authority (NCA) community in Europe would read “could do better, must do better, will do better”.
The release of the report comes not long after the expedited interim ruling of a German court that found two individuals guilty of tax evasion through the use of Cum-Ex trades. These trades were found to have created conditions whereby tax reclaims were paid by the German tax authority on tax that had never been borne (and therefore couldn’t be “reclaimed”).
So, what does this mean for securities lending? I’ll start with the caveat that I am not a tax advisor, lawyer or registered representative. I suggest you “do your homework elsewhere” and I am not giving advice here, just sharing my personal views and opinions (that should make my lawyers sleep easier).
First, hands up anyone that thinks it was ever going to be acceptable to reclaim tax twice on a single dividend payment? (If your hand is up, get a lawyer – quickly because their calendars are filling up fast.)
Now let’s move to the uncomfortable issue that for many stocks in many markets, volumes rise around their relevant dividend payment period. Surely a sign of trouble? Not so fast. If all dividend arbitrage trading were unlawful, the EBA report would have made that clear and required the NCAs to stamp it out with extreme prejudice and quickly.
There are two questions one can apply when considering whether a transaction should be able to benefit from withholding tax differentials. If the following conditions are met, then a would-be trader can comfortably propose a transaction structure to management, internal and external tax and legal advisers for approval.
Would the transaction be economically viable without any withholding tax profit element? In other words, could you profitably execute the transaction outside of a dividend period? “Transaction” includes the full combination of long/short hedge components to the trade, whether in cash markets or through synthetics. Is it a real trade if it relies on withholding tax?
Is there real position risk created for the entity that would reclaim any tax? If the entity that would reclaim tax is acting simply as a convenient tax-advantaged parking spot for a long position, the reclaim could be open to challenge particularly if the economic performance of the stock accrues to the trader that has temporarily placed the holding. The risk is not with the reclaimer, so on what basis would they claim beneficial ownership?
Note: There are no doubt situations where neither condition above is met and yet you may have a case for a valid reclaim – this is an overview, not a comprehensive trader’s guide.
The common-sense concept is that traders should be able to profit through differentials in withholding tax rates of borrowed securities but shouldn’t be able to execute transactions that are only profitable because of those differences and aren’t real trades with real risks. Satisfy those requirements, and you are a long way down the road to an acceptable dividend arbitrage tax recapture – fail one or both, and you are building on a shaky foundation.
Should lenders be concerned with borrowers that might put the borrowed stock to use as part of a transaction that is subsequently ruled as tax evasion? A securities loan involves a legal transfer of title, enabling the borrower to take all actions the owner of a security is entitled to take. That could include making a claim on withholding tax that the borrower isn’t entitled to. However, that is outside the control of the lender. The analogy I would apply here is that if you transfer ownership of your car to someone who subsequently uses it as a getaway car for a bank robbery, the police won’t be knocking on your door. Practically, as an agent lender in the past, we did what we could to mitigate the risk of misuse by avoiding lending to entities that could directly claim tax benefits. Not perfect, but we weren’t going to make it easy for potential abusers and in any case we had no obligation even to do that much.
When there is a dividend or interest payment due during the life of a securities loan, borrowers are required to make a substitute payment to the lender that would put them in the same net cash position that they would have been in had they not loaned securities in the first instance. As a side comment, that means for markets where excess tax is reclaimed under appropriate Double Taxation Agreements, there is a cash flow advantage to the lender to have securities on loan. In any case, borrowers will always try to reduce their costs by borrowing around record dates from lenders that suffer a lot of withholding tax.
The table below shows a simple example with three lenders with different tax treatments. If a stock loan goes over a dividend payment period, a borrower will always hunt for the cheapest substitute payment to make, which in the example below is from the lender that does not benefit from any withholding tax reduction. So long as there are different rates of tax applied, at dividend times there will always be a demand to borrow from investors that suffer withholding tax. That is a cost-savings exercise, not an arbitrage and again, lenders should have no concerns with this.
Scrip dividends/optional stock dividends/dividend reinvestment plans all present trading opportunities with the potential for gain or loss but as they do not involve withholding tax differentials as their driver, it is not relevant for this conversation. More on this topic in a couple of weeks.
The EBA is rightly challenging NCAs to ensure that they take a robust and joined-up approach to the potential for what EBA terms “tax crimes”. After all, why should citizens of any country be subsidising abuse and paying for tax evasion? Importantly for securities lending, participants should not shy away from scrutiny over market practices. Double-dipping by a tiny number of individuals possibly with employer consent or poor oversight has dogged the securities lending industry. Time to pull back the curtains a little bit further.
I have looked at some simplistic scenarios here – still uncertain? At Pierpoint, we are seasoned professionals with broad current experience across a wide array of clients, and alongside either our or your trusted tax and legal partners, we can help you delve deeper into any questions or concerns you may have. Get in touch with us, so just like my lawyers, you will be able to sleep better at night.
And as to the “THEY” who didn’t want me to write this? You know who you are.