Two issues in Washington show the need for more reciprocal international agreements in taxation and pension funds. One issue involves a U.S. idea that would affect domestic pension funds that face foreign withholding taxes on foreign equity dividends. The other issue involves a group of European pension funds battling the Internal Revenue Service over their exemption from paying U.S. dividend withholding taxes.
With investing and economies becoming global, governments should seek equitable arrangements so pension sponsors can provide privately financed retirement benefits, no small matter with social security systems worldwide having financial problems.
In the first case, Congress would indirectly hurt pension funds for a constructive use of a derivative to limit their cost of investing overseas. The proposal would raise the cost of the derivative strategy.
The proposal affects the use of international equity swaps. Tax-exempt investors use this derivative because they are unable to use a tax credit for dividends withheld by foreign governments. Instead of buying foreign stocks directly, these investors use swap transactions to replicate the international returns.
The Clinton administration proposed to impose a 15- or 46-day holding period for taxable investors, who are the counterparties in the swaps and who can use the tax credit against their U.S. taxes for the withholding foreign governments place on dividends paid on foreign equity investments.
Under the proposal, these counterparties would face an investment holding period to be able to use the tax benefits. Foreign withholding typically amounts to 5% to 15% of the dividend, which is substantial on billions of dollars of investments.
Congress expects to raise $1 billion over a five-year period through the proposal. But like most congressional estimates it assumes institutional investors would continue to use the technique, when doubtlessly the institutions would look for other, newer avenues to reduce their costs.
One way would be for pension funds to take this business overseas, using foreign securities dealers, much to the chagrin of the U.S. dealer community. Non-U.S. dealers wouldn't be affected by the proposal.
Any tax revenue Congress raises surely would be to the detriment of pension funds, mainly defined benefit plans. These plans have been struggling to maintain the support of their sponsors, not only among corporations but also states and local governments. More investment complications sour sponsors more on providing defined benefit pension funds.
The administration idea could have broad appeal with Congress as both groups look for new revenue to reduce deficits on their way to balance the budget.
The administration and Congress ought to back off from this proposal. Or if they decide to pursue it, should give it a full public airing rather than include it as an obscure amendment in some omnibus legislation.
In the other case, European pension funds face demands from the IRS to pay taxes on U.S. dividends. The tax agency claims the funds failed to prove their eligibility for exemption as labor organizations. The matter has ended up in tax court and will take years to resolve with appeals expected at every step.
Clearly, the United States and other governments ought to start discussing ways to rationalize international exemptions for pension funds.