Banks' Move to Cut Hedge Funds' Dividend Taxes under Probe - Analyst Blog

An image of a globe with financial data surrounding it
Credit: Shutterstock photo

Dividend arbitrage - a trading strategy undertaken by big banks to aid hedge funds and other clients in reducing taxes - has drawn criticism from U.S. authorities, per a Wall Street Journal report. The banks earn over $1 billion in revenues in a year through this strategy.

What is the Strategy?

The banks reduce the client's tax by taking advantage of the differences in withholding tax rates in different countries.

Under dividend arbitrage, usually a bank enters into a stock swap, a derivative transaction with its client. In this transaction, the bank possesses the client's shares of a different company at time when the client expects receipt of dividend. In turn, the bank moves the shares to its subsidiary or third party in a country where lower tax or even no taxes would pertain to the dividend. Thus, holder of the shares realize higher amount of dividend.

The related parties in the transaction - bank, its client and the holder of the shares - divide the amount of tax savings among themselves. Following the transaction, some clients may choose to take back their ownership of the shares.

Bank clients' taxes on dividend payments gets lowered from 30% to 10% or even to zero through this strategy.

The Regulatory Concern

In 2008, dividend arbitrage came under the criticism of Senate investigators and gradually U.S. tax authorities took steps to address the issue. Owing to this, banks find it difficult to cut dividend taxes on U.S.-listed stocks. Currently, such a strategy largely operates from London and mostly involves European and Asian stocks.

While banks and hedge funds view the strategy as a legal one to trim down taxes, regulators are of a different opinion. Recently, Bank of America Corporation ( BAC ) has been questioned by the regulators "about potential legal and reputational risks from the maneuver". The Wall Street Journal quoted a spokesperson for Federal Reserve Bank of Richmond. According to the spokesperson, BofA is addressing the concerns raised.

It is not yet clear whether other banks have faced related queries. Other banks that structure similar strategy include Citigroup Inc. ( C ), Deutsche Bank AG ( DB ), Morgan Stanley ( MS ) and The Goldman Sachs Group, Inc. ( GS ).

Notably, last week, the U.S. Treasury Department came up with new stricter rules on corporate "inversion" deals, to minimize the tax-avoidance transactions.

Bottom Line

As banks are already combating a number of challenges including a competitive environment, escalating costs and a persistent low environment, they are on a continuous look out for strategies to ease pressure on revenues. Addition of stricter regulation on this will further weigh on the business model of banks.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

MORGAN STANLEY (MS): Free Stock Analysis Report

DEUTSCHE BK AG (DB): Free Stock Analysis Report

CITIGROUP INC (C): Free Stock Analysis Report

GOLDMAN SACHS (GS): Free Stock Analysis Report

BANK OF AMER CP (BAC): Free Stock Analysis Report

To read this article on click here.

Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story


Other Topics


Latest Markets Videos


Zacks is the leading investment research firm focusing on stock research, analysis and recommendations. In 1978, our founder discovered the power of earnings estimate revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank. A wealth of resources for individual investors is available at

Learn More