Hedge Fund Tax Savings In Fed’s Crosshairs

A hedge-fund tax-reduction strategy is getting some unwanted attention from the Federal Reserve.

The Federal Reserve Bank of Richmond this year questioned Bank of America about its dividend arbitrage strategy for hedge funds and other clients. Under that system, banks temporarily transfer ownership of a client’s shares to a lower-tax jurisdiction before a dividend is paid out, a move that can cut taxes from up to 30% to as little as nothing. The bank, client and temporary owners then split the savings.

Dividend arbitrage is offered by a number of banks, including Citigroup, Deutsche Bank, Goldman Sachs and Morgan Stanley, and generates more than $1 billion in revenues for them. But the Richmond Fed warned that the service raises potential legal and reputational risks for banks, and has passed its concerns on to the rest of the Fed system.

Among the hedge funds employing dividend arbitrage are Citadel Investment Group, Lansdowne Partners and Och-Ziff Capital Management, The Wall Street Journal reports.

Dividend arbitrage isn’t new: It was criticized by U.S. Senate investigators in 2008 and has been reduced by the closing of U.S. tax loopholes. But it remains “a very profitable trade for hedge funds and broker-dealers,” S3 Partners’ Ihor Dusaniwsky told the Journal.