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.