U.S. regulators are turning a critical eye to the practice of dividend arbitrage, as banks rake in over $1 billion in annual revenue by exploiting the strategy, reports The Wall Street Journal. The strategy used to be an even bigger business earlier, before U.S. tax authorities made it harder to shrink dividend taxes on U.S.-listed stocks.

Dividend arbitrage: A low-down on the strategy

The complicated “dividend arbitrage” strategy is run largely from London,  according to a report in the Wall Street Journal by Jenny Strasburg, where banks temporarily transfer ownership of a client’s shares to a lower-tax jurisdiction around the time when the client anticipates to collect a dividend on those shares. Banks and hedge funds say the strategy is an attractive, legal way to shrink tax bills through the differences in withholding rates around the world.

The strategy typically allows bank clients to shrink taxes from as much as 30% of the dividend payment to 10% or so, sometimes even to zero. The savings generated from the strategy are divided between the client, bank and entities that take ownership of the shares.

After criticism by Senate investigators in 2008 and the plugging of loopholes by U.S. tax authorities, banks generally have shifted the focus of their dividend-arbitrage work to London. The strategy largely hovers around stocks listed in Europe and Asia. Moreover, other countries have made it harder to use the strategy with shares of companies listed or based there.

The following graphic captures how banks use the strategy to help clients reduce taxes:

Dividend arbitrage

 

Thanks to the Obama administration’s efforts to crack down on tax inversions last week, the U.S. Treasury Depart. unveiled tough new rules on corporate inversion deals that are aimed at making tax-avoidance transactions less desirable.

Bank of America questioned

According to a spokesman for the Federal Reserve Bank of Richmond, Bank of America Corp (NYSE:BAC) was recently questioned by U.S. regulators about potential legal and reputational risks from the dividend arbitrage practice. Citing clients and people involved in the business, The Wall Street Journal reports that other banks which arrange similar transfers of corporate stock include Citigroup Inc. (NYSE:C), Deutsche Bank AG (NYSE:DB) (ETR:DBK) (FRA:DB), Goldman Sachs Group Inc (NYSE:GS) and Morgan Stanley (NYSE:MS).

Some hedge funds such as Lansdowne Partners Ltd. and Och-Ziff Capital Management Group LLC (NYSE:OZM) have benefited from the maneuver as well. Interestingly, some clients derive benefits through lower trading costs and financing rates on their overall business with major banks without explicitly telling the banks to shift a stock’s ownership to a lower tax jurisdiction.

Citing people familiar with internal estimates, the Journal reports that last year, Bank of America estimated that trades aimed at helping clients reduce withholding taxes on stock dividends generated over $1.2 billion for the bank from 2006 to 2012, while the bank anticipated getting $100 million in revenue from the trades in 2013, mostly from Europe.

According to the Economist, over $1.5 trillion worth of shares and bonds are on loan at any time for use in the strategy.