Fed questions BofA on tax strategy for hedge funds

Bank of America has been questioned by U.S. regulators over a strategy that helps hedge funds and other large clients reduce their taxes on dividend payments.

In the strategy, known as “dividend arbitrage,” a bank moves ownership of a client’s shares to another country with a lower tax rate before the client is expected to collect the dividends on the shares. Experts say the technique, which is legal, can save the clients millions of dollars in taxes.

Dividend arbitrage also pays off for the banks, which can collect fees for making the arrangement.

The Federal Reserve Bank of Richmond, which oversees Bank of America, questioned the bank over the practice during one of its routine examinations of the bank. The Fed has not publicly announced any action against the bank over the issue.

“In the course of our regular and intensive supervision of Bank of America, we identified dividend arbitrage trading as an activity that required further examination of the risk and governance of the business,” Richmond Fed spokesman Jim Strader said in an email to the Observer. “Bank of America has cooperated with our examination of the practice.”

It is not clear when the Fed questioned the bank. Strader declined to comment further.

Bank of America largely runs the strategy from London, where it has European headquarters. Bank of America spokesman John McIvor declined to comment.

The process works like this, according to experts: Around the time a hedge fund expects to receive a dividend, it sells its stock to a bank or other financial institution. The institution transfers the shares to a third party, or to a subsidiary of the financial institution, based in a jurisdiction where the tax rate is lower than the rate where the hedge fund is based.

Dividend arbitrage could result in what might have been a 20 percent tax rate on a dividend being lowered to around 5 percent or zero, said Robert Willens, president of Robert Willens LLC, a New York-based tax-advisory firm.

“That’s 15 cents in savings that has been realized as a result of this transaction, and the 15 cents is divided up between the hedge fund and the bank,” he said.

The maneuver can save an individual hedge fund millions of dollars in tax payments, he said.

The practice is not unusual, Willens said. But, he said, banks typically offer the service to large clients who own hundreds of thousands of shares.

“You have to have a large amount of stock to make this all worthwhile for all the participants.”