A recent article posted by the UK’s Guardian painted dividend arbitrage in a nefarious light, with the potential for allegations of mischief. In fact, dividend arbitrage is a neutral practice in today’s financial markets and exists simply because of tax competition between countries. This post looks at the pros and cons of the practice including an analysis of the Guardian article.
Dividend arbitrage provides a revenue opportunity that takes advantage of different tax rates between legal jurisdictions and legal entities. As with any regulatory arbitrage, revenues have developed based on this opportunity that provide alpha to investment firms and corporations, and that pay for custodial and other asset services. Dividend arbitrage is not a reason to purchase a security but rather an additional revenue generation that comes with ownership.
There is nothing problematic or nefarious about dividend arbitrage; it brings with it no operational nor market structure issues beyond the normal practice of financial institutions. The Guardian article mentioned a sort of white washing scheme involving hedge funds in offshore vehicles. The more mundane reality is that most dividend arbitrage occurs on behalf of pensions, mutual funds and other institutions. These firms legally benefit from differences in international tax rates.
While the scale of dividend arbitrage revenue lost to government tax officers is unknown (although the Guardian article does a back-of-the-envelope calculation of US$775 million annually), it is certainly popular enough that governments are aware of it. However, dividend arbitrage is less of a concern than competition between jurisdictions to attract certain types of industry or wealthy residents. Tax harmonization or tax coordination would result in an elimination of both competitive tax treatment for industry as well as dividend arbitrage, but this will also require national governments to be willing to give up some of the tools at their disposal for taking an economic advantage over other jurisdictions. That will be a difficult pill to swallow in any economic environment let alone this one.
The unfortunate truth is that any regulation creates winners and losers in nearly every scenario. Dividend arbitrage has been the result of regulatory arbitrage between jurisdictions. Harmonizing tax withholding rates on dividends will create a new regulatory opportunity. This is simply the nature of regulation.