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Synthetic prime brokerage and the risk of tax recharacterisation: Difference between revisions
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Synthetic prime brokerage and the risk of tax recharacterisation (view source)
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{{a|pb|}} | {{a|pb|[[File:Dramatic Chipmunk.png|thumb|center¬DID SOMEONE SAY [[recharacterisation¬RECHARACTERISATION??]]}} | ||
===Why there is no real risk of a [[synthetic equity]] position being a secret custody position doing the tax man out of his money=== | ===Why there is no real risk of a [[synthetic equity]] position being a secret custody position doing the tax man out of his money=== | ||
Controversial view, perhaps, but the tax disposition which led to someone inventing the [[hypothetical broker dealer]] — a creature as beloved of the [[equity swap]] market as the [[reasonable man]] is of the [[common law]] — is, in this | Controversial view, perhaps, but the tax disposition which led to someone inventing the “[[hypothetical broker dealer]]” — a creature as beloved of the [[equity swap]] market as the [[reasonable man]] is of the [[common law]] — is, in [[this commentator]]’s view, predicated on a fundamental misapprehension as to how a [[synthetic equity swap]], and the [[hedging]] and financing behind it, works. | ||
This fear of “[[recharacterisation]]” — obligatory nod to our [[dramatic look gopher]] — also disregards the [[IRS]]’s known acknowledgment that [[synthetic equity swap]]s are a thing; a bona fide class of transactions of genuine utility and wide use in the market. | |||
====So what is the problem?==== | ====So what is the problem?==== | ||
The putative concern is that, should there be too close a connection between an equity swap and the means by which the swap [[dealer]] hedges it, thew dealer could be judged to be “acting as nominee owner” of the hedge for its client — a sort of undisclosed [[custodian]] — meaning the client becomes liable to that universe of stamp taxes and withholdings that apply to actual transactions in equity securities, but do not apply to swaps. | The putative concern is that, should there be too close a connection between an equity swap and the means by which the swap [[dealer]] hedges it, thew dealer could be judged to be “acting as nominee owner” of the hedge for its client — a sort of undisclosed [[custodian]] — meaning the client becomes liable to that universe of stamp taxes and withholdings that apply to actual transactions in equity securities, but do not apply to swaps. | ||
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The [[dealer]]’s existing hedge inventory is (a) constantly churning, (b) does not translate 1:1 with each individual long client position. At any time, the [[dealer]]’s long exposure to a given cash security will equal its net long exposure across ''all'' clients, long and short, in the [[dealer]]’s whole book. The [[dealer]]’s total holding is a function of its total client portfolio shape, not that of any individual client. | The [[dealer]]’s existing hedge inventory is (a) constantly churning, (b) does not translate 1:1 with each individual long client position. At any time, the [[dealer]]’s long exposure to a given cash security will equal its net long exposure across ''all'' clients, long and short, in the [[dealer]]’s whole book. The [[dealer]]’s total holding is a function of its total client portfolio shape, not that of any individual client. | ||
Therefore, if the book is 500 long and 300 short, the [[dealer]] will hold just 200 positions. If the 500 long clients want the [[dealer]] to vote their shares they’re — out of luck | Therefore, if the book is 500 long and 300 short, the [[dealer]] will hold just 200 positions. If the 500 long clients want the [[dealer]] to vote their shares they’re — ''out of luck''. | ||
Nor does the [[dealer]] hold continuous positions in shares for the life of any transaction: It buys and sells every day to reflect changes in its net aggregate exposure caused by all client activity. It churns. Therefore: | Nor does the [[dealer]] hold continuous positions in shares for the life of any transaction: It buys and sells every day to reflect changes in its net aggregate exposure caused by all client activity. It churns. Therefore: | ||
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*All swap clients are at risk of hedging disruption ''every day'' whether or not any particular one has adjust its own position. | *All swap clients are at risk of hedging disruption ''every day'' whether or not any particular one has adjust its own position. | ||
====The [[dealer]] lends out its aggregate long position by [[title transfer]] | ====The [[dealer]] lends out its aggregate long position by [[title transfer]]==== | ||
And then we consider the financing operation of the [[dealer]]’s swap book into account. the [[dealer]] generally lend most, if not all, of the [[dealer]]’s net aggregate long position out into the market every day. It does this by [[title transfer]]. Where it can, it will lend the ''whole'' book out. It doesn’t, generally, hold any more physical securities hedges, as legal owner, at all. | And then we consider the financing operation of the [[dealer]]’s swap book into account. the [[dealer]] generally lend most, if not all, of the [[dealer]]’s net aggregate long position out into the market every day. It does this by [[title transfer]]. Where it can, it will lend the ''whole'' book out. It doesn’t, generally, hold any more physical securities hedges, as legal owner, at all. | ||
None of these things are consistent with a physical, enduring holding that could resemble a | None of these things are consistent with a physical, enduring holding that could resemble a “nominee ownership”. It is clearly, categorically, a purely ''economic'' [[exposure]]. The point is it is not that the [[dealer]] isn’t a nominee owner for a given client according to the legal theory, but that it isn’t a nominee, or ''any'' kind of owner, ''at all''. | ||
====The IRS position on the product generally==== | |||
As far as we know the IRS labours under no illusions about the synthetic equity swap product, understands it and is comfortable with how it trades. This is why it introduced [[871(m)]]. “High delta” equity derivatives are a widely traded, liquid, and standardised product; the IRS understands it, accepts it, and has already taken direct measures to ensure they are taxed appropriately (ie 871(m)). The [[IRS]]’s goal is to stop [[dealer]]s disguising nominee ownership arrangements, not to stop them paying the [[delta one]] value of securities to clients under genuine swap contracts. If that were their aim, the “[[hypothetical broker dealer]]” language wouldn’t work anyway; the [[dealer]] would have to adjust the [[delta]] ''away'' from 1 by a meaningful amount. In turn, that would significantly transform the product: the point of the synthetic equity swaps is to exactly replicate the performance of a stock through derivatives. It is hard to see the IRS’s interest in targeting legal “[[verbiage]]” to see if they catch [[dealer]]s out by extracting tax from those who have forgotten to use the word “hypothetical” here or there in a master confirm. If that were a genuine risk, the [[dealer]] should not be doing this business at all. | |||