Do you ever see people do things that just make you shake your head? This week, I read about a financial services company that engaged in an equity trading program that functioned like a long / short strategy but was also designed to capture tax benefits from the dividends paid on the long portfolio. In Field Attorney Advice 20131902F (the “FAA”), the IRS opined that the taxpayer was not entitled to the tax benefits. Normally, when one U.S. corporation owns stock of another U.S. corporation any dividends received on such stock are entitled to a dividends received deduction ( DRD). The amount of the deduction is equal to 70% of the dividend; But it can be more if there is a significant level of share ownership. This results in an effective corporate tax rate of 10.5% on the subject dividend amount – a significant tax benefit. The DRD is normally not permitted if the taxpayer hedges its risk of loss with respect to the stock. This same rule applies with respect to qualified dividend income (QDI) for stock held by individuals. However, certain types of hedging are permitted while receiving the DRD / QDI benefit such as market hedging. That is, you can own IBM and short the S&P500 without interfering with the tax benefit. This type of hedge is known as a portfolio hedge and is very common.
In the quintessential portfolio hedge, the investor owns a portfolio of dividend paying equities. The investor then hedges that portfolio with a short position (e.g., a put option), with respect to the broader market. The “broader market” could be a broad based index like the S&P 500 index or it could be a bespoke portfolio of securities. This is an example of a taxpayer hedging one equity portfolio with a different portfolio (note, the portfolio utilized to hedge the equities may be made up of securities other than equities). However, taxpayers have also utilized portfolio hedging to protect a single stock like the IBM example above. In this case the taxpayer is hedging a single equity with a position in a portfolio.
The use of portfolio hedging is sanctioned by Treasury regulation section 1.246-5(c). That section permits portfolio hedging without impairing the DRD / QDI benefit provided there is not “substantial overlap” between the position and the taxpayer’s stock holdings. Substantial overlap is considered to be 70% based on fair market value. In order to constitute a “portfolio” for this purpose the position must consist of at least 20 different issuers. As such, a portfolio hedge can normally be achieved if the offsetting position is with respect to a broad based index like the S&P500 (although one always needs to be aware of the anti-abuse rule contained in Treasury regulation section 1.246-5(c)(1)(vi) which disallows the tax benefit if the short position “virtually tracks” the long position). Note, portfolio hedging is not always as easy as it seems. Take my example of IBM above. Suppose the investor elects to hedge by purchasing a put option on the Dow Jones Industrial Average (the “Dow”). The Dow is a price weighted average of 30 different issuers, IBM being one of them. In fact, IBM is currently the largest percentage member of the index representing almost 10.5% of the index (price weighting is not a good idea when devising an index). This still meets the 70% overlap threshold but one needs to be careful and not assume an index is broader than it really is.
The FAA has partially redacted facts so we can’t see exactly what was going on; But, it appears the taxpayer intentionally violated the 70% overlap limit. Then, in order to obfuscate the issue, the taxpayer in the FAA held the long equity positions at its parent entity and held the offsetting positions (options on the S&P 500), in subsidiary corporations. The parent and the subsidiaries all filed a consolidated tax return. The straddle rules provide for finding a straddle among related taxpayers. Section 1092(d)(4). Likewise, the DRD rules prohibit the deduction where the offsetting position is held by a related party, but there the IRS must find that the taxpayer held such positions “with a view to avoiding the application of section 1.1092(d)-2.” Treas. Reg. section 1.246-5(c)(6). While the FAA does not address this latter rule in a substantive way it does find that taxpayer was not entitled to the DRD benefit due to the short positions held by its subsidiaries. Importantly, the FAA states that even if the taxpayer demonstrated legitimate non-tax business reasons for the positions it would not “alter the conclusion that the options were executed with the circumscribed purpose…”
There are legitimate methods to protect an equity position and preserve the related tax benefits. Moreover, you can use these same methods to hedge a long position in almost any security and “age the position” to a long term holding period if desired. The lesson taught by the FAA is that you have to be smart and careful about entering into transactions like these. If you have interest in hedging transactions or any other financial transactions please contact your normal WithumSmith+Brown partner.