A December 2019 decision from the Supreme Court of Switzerland verified that the entity which holds securities in a securities lending transaction is not the beneficial owner of dividends issued against those securities. The tax ramifications of this decision have been criticized by large investment banks and other parties that borrow stocks for short trading and other related purposes. This decision, however, is entirely consistent with how dividends are typically treated in nonrecourse stock lending transactions.
In the transaction that the Court reviewed, a Luxembourg-based financial institution took possession of shares that were owned by a Swiss entity. The Luxembourg institution paid a “manufactured dividend” to the Swiss entity in anticipation of the actual dividend that the issuer was about to declare. Under applicable laws and treaties, the Swiss government implemented a 35% tax withholding from that manufactured dividend. The Luxembourg institution then sought a refund of a portion of those withheld taxes after the issuer declared and paid its regular dividend. The Swiss tax administration denied the claim, and that decision was affirmed by the Swiss Supreme Court.
In pertinent part, the Court based its decision on the conclusion that the Luxembourg institution was not the beneficial owner of the dividends. The Court rejected a regulatory argument that relied on a guidance followed by the Swiss tax administration, stating that the guidance was not binding on the Court’s decisions, and in any event, it was not clear enough to direct the Court’s actions.
Tax professionals who reviewed this decision note that it is consistent with recent Swiss holdings that have denied beneficial ownership of Swiss dividends where taxpayers have held shares in hedge-swap and other complex transactions. Those professionals are recommending that where a potential for a refund of withholding taxes exists, both a stock borrower and lender should remain cognizant of how best to structure a transaction to optimize its tax effects.
The complexity of the underlying facts in this decision and the laws and regulations that justified its holding may not be relevant in the context of a more straightforward nonrecourse stock loan transaction, in which the owner of securities pledges his or her stock as collateral for a cash loan. In stock loan transactions that are originated by reputable financial institutions, any dividends that are declared on collateral stock are held for the benefit of the stock pledgor. When that pledgor repays the principal balance and outstanding interest on a loan, the dividends are returned to the pledgor along with the collateral stock. Alternately, the pledgor can direct the dividends to be applied toward the principal balance and interest.
As the decision from the Swiss Court makes clear, in both complex securities lending transactions and simpler nonrecourse stock loans, the person or entity that transfers securities to another party should retain experienced legal, financial, and tax counsel to review the transaction and all of its tax implications before proceeding with the transaction. A decision such as the one that the Swiss Court issued in late 2019 might always run contrary to the parties’ plans and expectations, but the administration of complex transactions will always benefit from professional oversight and due diligence before the transaction is closed.