LEPO's: Dividend tax avoidance in an international context

For foreign investors desiring exposure to the equities of companies resident in countries with withholding taxes, and where those investors are not situated in a country with suitably low treaty-based withholding tax limitations, one solution offered by a number of investment banks has been to issue instead to the investor low-exercise price options (aka LEPO's) on those equities.

With a strike price of a few pence, these options had a delta of roughly one, i.e. movements in the share price value would be reflected in movement of the option value, giving roughly the same economic exposure to share price movement. The option price took into account the expected dividends, the bank hedged its exposure on the option by purchasing the underlying share.

Of course, dividend payments to a tax resident company were not subject to a withholding tax on dividends, and when the counter-party wished to exit its investment, it could:
a) exercise the option and take delivery, and immediately dispose of the share in the open market,
b) waive its rights under the option for consideration from the option writer, or
c) on sell its option to a third party, who may or may not have been resident in the UK.

The exact adjustment to the price of the option written would be calculated to share the economic gain between a value calculated based on the original taxed dividend expected to be received by the holder and the value of such an option to the writer, who would receive the dividend free of this tax.

This method could be equally applied in a country which used an imputation system of taxation, such as Norway, using appropriate adjustments.

Principles of tax planning

Broomberg has suggested that the taxability or deductibility of any amount is affected primarily by its source, timing, incidence and nature.

The source of an amount of income affects which jurisdiction or jurisdictions, if any, are entitled to tax that particular amount. Though South Africa and a lot of other countries operate residence-based taxation systems for residents, income source is still highly relevant in a cross-border context.

The timing of the incurral of a tax, when considered in light of the economic time value of money, can dramatically affect the economic cost of a tax. In the extreme case, an effectively permanent deferral of tax can translate a taxable receipt into a tax-free receipt.

Incidence refers to the person or entity whose is treated as the recipient of an amount of income for tax purposes. A particular taxpayer may have tax-advantaged status, either due to an exemption or a tax loss position, and different taxpayers may pay tax at different rates. In South Africa, pension funds are generally not subject to income tax, while individuals have a marginal tax rate of 40% and companies a tax rate of 29% before dividends tax.

The nature of a receipt or accrual affects under which provisions, if any, an amount is subject to tax. The capital and revenue distinction and differential tax rates thereon in South Africa is a classic example. Various conversion methods are applied in attempts to convert income from a highly-taxed form into a lowly-taxed one.

I believe this framework to be a reasonably good one, and will endeavour to comment on structures with reference to these factors. When faced with a tax problem, ask yourself if there are any ways in which you can affect the source, timing, incidence or nature of any receipts, and if any of these ways will reduce your ultimate economic tax cost (aka "fiscal drag").

Welcome to tax0r

The intention of this blog is to examine various smart, and not-so-smart, tax avoidance and minimisation strategies that have been employed over the years and in different jurisdictions and sometimes also to pass comment on various tax, finance and accounting-related matters.

The title 'tax0r' is a play on the IT/information security term 'hax0r'. I see strong parallels between tax planning and hacking: both involve understanding complex systems better than the designers of those systems in a way that allows one to exploit inconsistencies or discontinuities to achieve unexpected outcomes and both are often an intellectual battleground for some sharp minds.

Hopefully you will derive some value, whether it be in the form of amusement, ideas, shock or even a minimal understanding of what happens out there, from this work.

Enjoy the ride!