The enforcement division of the CFTC is investigating dividend arbitrage trades at five major banks. It sent inquiries to Bank of America, Citigroup, Deutsche Bank, Goldman Sachs and Morgan Stanley late last year.
Large banks around the world reportedly generate more than $1 billion a year by helping clients reduce their taxes through these types of trades. The Wall Street Journal reported last year that Bank of America earned revenue of approximately $1.2 billion from 2006 to 2012 and projected $100 million from the trades (mostly in Europe) in 2013.
One form of these trades is commonly referred to as “cum/ex trades” because of its ties to the cum-dividend and ex-dividend status. The clients enter into agreements to sell or loan their shares prior to a dividend payment and buy or receive the securities back after the payment has been recorded. The transaction allows clients to avoid taxation of their dividend payments.
By arranging for foreign entities in nations with favorable tax laws to hold the shares and receive the dividend, they are able to avoid the substantial tax payments the bank’s client would have had to pay in their home country.
There have also been allegations in media reports that the credits some dividend recipients are entitled to in countries with favorable tax laws have been fraudulently claimed by more than one party in these transactions. As a result, nations paid duplicate tax credits.
Although some nations are pursuing the transactions for violation of their tax law, the CFTC is investigating the transactions for violations of the securities laws. The CFTC has already filed and settled a case against Royal Bank of Canada for engaging in similar transactions to lower the taxes it pays to Canada with futures trades. The Canadian bank agreed to pay $35 million to the CFTC to resolve the lawsuit at the end of 2014.
The CFTC filed it in 2012 under the theory that they were illegal wash trades. The CFTC alleged more than a thousand wash trades in futures were made to provide the bank with hundreds of millions in tax benefits in Canada. The off-exchange transactions used affiliates to conduct the trades but were reported as block trades between independent parties. Aitan Goelman, director of enforcement at the CFTC, described the wash trades as illegal and not innocuous. According to Goelman, they provide misleading signals to the market and are prohibited regardless of the reason.
The CFTC is not the only government agency to be investigating this practice. The Federal Reserve Bank of Richmond has expressed concern about the use of some of these transactions by Bank of America. The Richmond Fed questioned the bank, which it oversees because of its headquarters in Charlotte, and passed along the information to the Federal Reserve.
The Wall Street Journal reported that Bank of America used its US government-backed subsidiary to finance billions of dollars of transactions. Although the United States shutdown the tax loophole a few years ago, the bank used its insured deposits to fund transactions for clients to avoid overseas taxes, mostly in Europe. It has since phased out the practice.
The Dodd-Frank Act expressly prohibited this type of action in the swaps push-out rule. However, Congress repealed it before it went into effective as part of the FY 2015 Cromnibus bill at the end of last year.
The Internal Revenue Service closed the loopholes which allowed overseas clients to dodge U.S. taxes shortly after a 2008 staff report was published by the U.S. Senate Permanent Subcommittee on Investigations on the practice.
Although the tax benefits of the transactions were shut down in the United States, banks continued these practices to help clients gain tax benefits in Europe and Asia. Authorities at the UK, Switzerland, and Germany are among the other countries investigating these practices.
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