Regulators Increase Scrutiny On Banks Over Tax-Avoidance Derivatives

Financial regulators are heightening their focus on banks involved in complex international trades designed to skirt taxes, the Wall Street Journal reports. The Commodity Futures Trading Commission sent letters to five firms reportedly involved in the exotic transactions, which have already drawn scrutiny from the Federal Reserve and international authorities.

Banks defend the so-called dividend-arbitrage trades, arguing that they are perfectly legal and beneficial to clients. Banks reportedly made over $1 billion last year offering the transactions, which take advantage of international tax policy quirks to ease the tax burden for hedge funds and other investors.

The CFTC sent inquiries to Bank of America, Goldman Sachs, Citigroup, Deutsche Bank and Morgan Stanley, according the Journal. Banks have centered the practice in their London divisions, which have access to European markets where tax policies vary widely.

Bank of America reportedly pioneered dividend-arbitrage trades in 2011 in an effort to draw hedge funds to its European investment banking arm. Clients enjoy a reduction in taxes from around 30 percent to 10 percent, savings which are shared with the bank and other participants.

The maneuver came under further scrutiny earlier this year when it was revealed that Bank of America was using its federally insured retail banking arm to conduct the trades. The revelation attracted widespread criticism. Banks are discouraged from using federally insured units to conduct trades that carry reputational risk.

The complex trades at the center of the inquiry begin with a hedge fund looking to reduce the tax burden on dividend-paying stocks, often involving European investments. In order to avoid taxes on the dividends, the bank acts as an intermediary between the hedge fund and a foreign institution whose local tax laws are more forgiving. This entity collects the dividends then routes the savings back through the bank to the original hedge fund.