International equity swap transactions would become more expensive for tax-exempt investors under tax law changes proposed by the Clinton administration.
While still on the political back burner, a part of the Clinton administration's third Taxpayers' Bill of Rights proposes a holding period for investors wishing to credit foreign equity dividend withholding against their U.S. taxes.
Under current rules, tax-exempt investors investing outside the United States are unable to use a tax credit for dividends withheld by foreign governments, and as a consequence may use derivative transactions, such as swaps, to recapture part of that lost dividend.
The Clinton proposal, though, would make swaps more costly for tax-exempt investors because U.S. counterparties to the swaps effectively would be prevented from claiming a dividend tax credit as well.
Robert Gordon, president of Twenty-First Securities Corp., New York, and chairman of the Tax Policy Committee of the Securities Industry Association, said the proposal is likely to be pursued by Congress, and tax-exempt investors should be concerned.
The proposal will reduce the choices available to tax-exempt investors, and now is the time for them to speak up, Mr. Gordon said.
Of course, the proposal would affect securities dealers as well.
As now written, the proposal could affect financial institutions' hedging of securities in inventory as well as short-term trading, said Lewis Steinberg, partner with the law firm Cravath, Swaine & Moore, New York.
And because the plan is a revenue raiser for the government, Mr. Steinberg said the proposal is less likely to die on the vine, given the government's desire to balance the budget.
The proposal is expected to raise about $1 billion over a five-year period.
Selected pension fund managers have used swap transactions to replicate international equity returns (Pensions & Investments, Feb. 17). Included in that group are the San Diego County Employees' Retirement Association, San Diego; the Illinois State Board of Investment, Chicago, which oversees three state employee pension funds; and the Michigan Department of Treasury, Lansing, which oversees four state employee pension funds.
"The thing that made EAFE swaps attractive is exactly this issue," said Richard Rose, chief investment officer for the San Diego County fund, in reference to swaps that produce the returns of the Morgan Stanley Capital International Europe Australasia Far East Index.
In some cases where countries withhold dividends, U.S. investors don't get all of it back, Mr. Rose said.
San Diego County uses swaps to replicate the total returns of selected foreign equity markets.
Roland Machold, director for the New Jersey Division of Investment, Trenton, which invests internationally but doesn't use swaps, said investment executives there are able to recapture most of the withheld dividends, but the process requires cutting through a lot of red tape. He noted that for some reason, the Italian government is particularly demanding on the issue of getting withholding back.
For international fixed-income securities, the amount withheld can be more significant, he said.
Another area where the burden of dividend withholding is particularly heavy is Latin America. Mr. Steinberg, the attorney, noted that in Latin American countries without treaties, dividend withholding can be much higher than the typical 5% to 15%.
Perhaps a bigger issue, which would affect investors indirectly, is the impact the proposal would have on trading and hedging of dealer inventory, lawyers say.
Because non-U.S. dealers wouldn't be subject to the provision, and generally are able to take similar credits in their home countries, U.S. securities dealers would be at a disadvantage.
"If the proposal does become law, it is important that Congress implement it in a way that doesn't unfairly disadvantage U.S. securities firms compared with European counterparts," said Edward Kleinbard, partner with the New York law firm Cleary, Gottleib Steen & Hamilton.
