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June 1, 2012

Tax Aversion

Industry Fights IRS Initiative

By Peter Chapman

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Proposed U.S. tax rules that target offshore hedge funds have come under fire by the options industry. The U.S. Securities Market Coalition, a lobbying organization that represents the options exchanges, along with the Options Clearing Corp., the Chicago Board Options Exchange, and the Securities Industry and Financial Markets Association, have all advised the U.S. Treasury to back away from imposing a dividend withholding tax on foreign options traders.

"If adopted as proposed," Joe Corcoran, the OCC's head of government relations, said at this year's Options Industry Conference, "we believe the regulations could have a negative impact on the listed options market by curtailing their use by foreign persons."

At issue is proposed Section 871(m) of the U.S. Tax Code, which seeks to combat tax evasion by foreign investors in U.S. securities. The roots of the proposal go back to 2008, when the U.S. Senate published a report that claimed offshore holders of U.S. stocks were using equity swaps to mimic the benefits of stock ownership but avoid taxes on dividends.

The new rule is part of the government's sweeping Foreign Account Tax Compliance Act, or FATCA, enacted in 2010 as part of the Hiring Incentives to Restore Employment Act. FATCA primarily targets tax evasion by U.S. persons holding investments in offshore accounts.

And while FATCA is mostly intended to require U.S. citizens and foreign banks to report assets held in foreign accounts, the aim of the Internal Revenue Service's proposed Section 871(m) is to require U.S. brokers to withhold taxes on any portion of payments made under certain stock derivative trades that are deemed the equivalents of dividends on the underlying stocks.

The fear is that brokers are collaborating with their foreign customers to evade U.S. withholding taxes on dividends. Under a typical arrangement, an offshore hedge fund with a stock position would temporarily sell the stock just after a dividend was announced; enter into an equity swap; and then, after the ex-dividend date, exit the swap position and buy back the stock. The scheme supposedly allows the hedge fund to maintain economic exposure to the stock, capture the value of the dividend, yet avoid the 30 percent tax on the dividend.

Although proposed Section 871(m) primarily targets equity swaps and stock loan transactions, Treasury has extended it to options, forwards and futures. That has alarmed the options industry. According to estimates by CBOE, foreign investors account for between 15 and 20 percent of the volume traded in U.S. listed options contracts. A study done last year by TABB Group estimated that European investors accounted for 10 percent of listed volume.

The options industry argues the rule shouldn't be applied to listed options contracts for two main reasons. First, unlike swaps, typical options trades do not confer the risks and rewards of stock ownership on the trader. A buyer of a call with a strike price that is out of the money-or higher than the price of the stock-by, say, 10 percent, "does not participate in any upside in the stock until it has increased by 10 percent," the Coalition told the IRS. At the same time, the holder's downside is limited to the premium, the Coalition noted.