The enforcement of withholding tax on dividend equivalents (2010)

The third example of cognitive heuristic is the enforcement of withholding tax on dividend equivalents in 2010. Before 2010,payments of US-source dividends to nonresident stockholders generally were subject to a 30% US withholding tax without tax treaties, under which dividend withholding was reduced to 15% for portfolio dividends and 5% for direct dividends (Avi-Yonah, 2008). By contrast, payments under most equity derivatives historically were not subject to withholding tax, even if the derivatives were contingent upon US-source dividends (Miller & Schwartz, 2016).The background rule was that payments on derivatives were sourced to the residence of the foreign recipients and thus not subject to US withholding tax.2” Therefore, foreign investors could avoid withholding tax on dividends by receiving dividend equivalents through equity swaps or stock loans.

In 2010, Congress enacted I.R.C. section 871(m), extending dividend withholding to dividend equivalents under derivatives that reference US equity securities. This rule was the result of the availability heuristic targeting financial transactions designed for dividend tax dodging purposes.

Cognitive heuristic

Before the enactment of section 871(m), increasing non-US stockholders were known to escape from the dividend taxes that they owed. In the early 2000s, several banks entered into so-called “yield enhancement”, “dividend enhancement”, and “dividend uplift” strategies with foreign hedge funds that used derivatives to eliminate dividend withholding on US equities (PSI, 2008). One main scheme was equity' swaps. Under equity' swaps, a foreign hedge fund transferred its US stock to a bank shortly before the stock’s ex-dividend date, and then entered into an equity swap with the bank that referenced the stock, thereby' preserving the fund’s economic position with respect to the stock (Avi- Yonah, 2008).This permitted the fund to receive substitute dividend payments under the equity swap free of withholding and to reacquire the stock shortly after the dividend payment.

The availability' of the dividend tax dodging problem caught attention and led to congressional action. On September 11, 2008, the Senate’s Permanent Subcommittee on Investigation (PSI) organized a hearing and issued a bipartisan Staff Report (PSI Staff Report) on dividend tax dodging (PSI, 2008).[1] [2] PSI recognized the Government Accountability Office’s determination that about $42 billion in dividend payments were sent abroad, but the IRS only received less than 4.5%, or SI.9 billion (GAO, 2007).The PSI investigation found that part of the reason for unpaid dividend taxes is that, for more than ten years, US financial institutions have been helping non-US clients dodge dividend taxes with equity swaps.[3] But in fact, this abuse of derivatives could be successfully attacked by the IRS on substance over form and economic substance grounds, therefore it did not require changing the law. Nevertheless, the hearing led to the enactment of I.R.C. section 871(m).

Due to the availability and representativeness heuristics, the attention of the legislature was misplaced to ignore more profound issues. Section 871 (m) applies to all dividend equivalents on notional principal contracts regardless of their purposes and is very complex. Though the dividend tax dodging is clearly a problem and could be addressed by section 871 (m), that section imposed unnecessary burden on derivative transactions without the intent of tax dodging. In addition, a related and more fundamental issue is whether dividends should be subject to withholding at all. In this sense, the underlying policy of section 871 (m) is mistaken because it makes no sense to insist on withholding dividends which are not deductible while not imposing any tax on deductible interest and royalties. Being not deductible, dividends are subject to double taxation on both the corporate level and withholding level.This problem was ultimately addressed by the Base Erosion Anti-Abuse Tax (BEAT) and the new' I.R.C. section 1630 during the 2017 tax reform.

Politicians’ own biases

The analysis above show's that cognitive heuristics influenced the enactment of 871(m). In making this decision, political actors w'ere subject to their own biases instead of following public pressure. Politicians’ anger at the bad actors as showm in the PSI investigation led to bad lawmaking, with no public pressure.

First, dividend tax dodging was not a high-profile public issue and w'as too technical to generate public pressure. Under the cover of complex financial transactions, the dividend tax dodging issue does not have simple and accessible fact patterns for the public to form strong opinions. Understanding the dividend dodging issue demands a distinction between financial transactions with the sole purpose of tax dodging, and financial transactions that are used for legitimate purposes, including sw'aps and stock loans that facilitate capital flows, reduce capital needs, or spread risks.23 To identify the tax dodging purpose, the public needed to understand the complicated transactions and see through the tricks, which demanded considerable information support and professional analysis. Without the resources available to politicians, the general public are unlikely to pay attention to such technical issues.

it helped clients dodge perhaps $115 million in US dividend taxes. For UBS, the figure is $62 million in unpaid dividend taxes over a four-year period, from 2004 to 2007. One hedge fund adviser, Maverick Capital, calculated that, from 2000 to 2007, its offshore funds used so- called dividend enhancement products from multiple firms to escape dividend taxes totaling nearly $05 million. In 2007, Citigroup surprised the IRS by paying $24 million in unpaid dividend taxes on a select group of swap transactions from 2003 to 2005, where no dividend taxes had been paid (PSI, 2008).

23 Opening Statement of Senator Levin, PSI Hearing Record, at 6.

Second, it was the anger at perceived abuses by politicians that drove a response that was dubious from a tax policy perspective. During the PSI hearing, PSI chairman Carl Levin and his Ranking Member Senator Coleman explicitly expressed their opposition to the dividend tax dodging acts, but their opposition was based on professional judgment of inappropriate dividend tax avoidance acts. Senator Levin said that, “What I oppose is the misuse of financial transactions to undermine the tax code, rob the US Treasury, and force honest Americans to shoulder the country’s tax burden”.[4] Senator Coleman described the abusive financial transactions as “shameless and cynical abuse of US tax policy”, and condemned that “inappropriate tax avoidance by a privileged few force[d] millions of honest American taxpayers to shoulder a disproportionate share of the tax base”.[5]

What made them even angrier is that many of these “foreign investors” are not truly foreign, but US persons investing through tax havens and avoiding their tax liability' on dividends. As Senator Levin said,

it adds insult to injury when hedge fund managers who live in the United States, enjoy all its benefits, protections and prosperity and use US markets to make money', arrange tax dodges so their offshore hedge funds escape the minimal US tax obligations they' are supposed to pay.[6]

They were unsatisfied that “for the last 10 years, as dividend tax dodging took hold and became an open secret among market insiders, the US Treasury Department and the IRS sat on their hands”,[4] and thus decided to take legislative action to stop it.


These three case studies show that political actors deviated greatly' from the principles of comprehensive rationality and applied cognitive heuristics as shortcuts in deliberating on US international tax rules. In all three cases, political actors employed the availability heuristic and the representativeness heuristic. They paid disproportionate attention to the vivid and dramatic events, and thus failed to conduct rational investigations of the issues. They also rushed to solutions without comprehensive evaluation of their benefits and costs, leading to their failure in solving the issues. More importantly, the three case studies display the role of political actors’ own biases. The public did not ask for the tax laws due to their technical and complicated nature; instead political actors enacted the laws on the basis of their own biases. The third example clearly shows that politicians were not just paying attention to voter biases, but made their own judgment in enacting irrational laws. In view of these findings, conventional rational-actor approaches inspired by “economic” versions of rationality need to take political actors’ own biases into consideration.


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  • [1] See Reg. §1.863—7(b)(1) (source of swap income generally determined by reference tothe residence of the recipient); Reg. §1.1441—4(a) (3)(1) (no withholding on swaps); Reg.§1.1441—2(b)(2) (i) (gains from the sale of property; including option premium and gains fromthe settlement of a forward contract, are not “fixed or determinable annual or periodicalincome” subject to withholding).
  • [2] For a complete record of this hearing including the PSI Report, see Dividend Tax Abuse: How-Offshore Entities Dodge Taxes on US Stock Dividends, Hearing before the PermanentSubcommittee on Investigation of the Committee on Homeland Security and GovernmentalAffairs, US Senate of the 111th Congress 2nd Session (Sept. 11,2008) (hereafter “PSI Hearing Record”).
  • [3] For instances, Morgan Stanley enabled its clients to dodge payment of $300 million in USdividend taxes from 2000 to 2007. Lehman Brothers estimated that in one year alone, 2004,
  • [4] Opening Statement of Senator Levin, PSI Hearing Record, at 6.
  • [5] Opening Statement of Senator Coleman, PSI Hearing Record, at 7—8.
  • [6] Opening Statement of Senator Levin, PSI Hearing Record, at 3.
  • [7] Opening Statement of Senator Levin, PSI Hearing Record, at 6.
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