As explained more fully below, total return equity swaps (TRSs) generally are contracts, often between a financial institution and a hedge fund, whereby the financial institution agrees to pay the hedge fund the total return of the reference equity during the swap term (including capital gains and dividends), and the hedge fund agrees to pay the financial institution the value of any decline in the price of the reference equity and interest on any debt embedded in the swap. In other words, the financial institution pays the hedge fund any upside, and the hedge fund pays the financial institution any downside plus interest. In this sense, the financial institution is the short party to the swap, and the hedge fund is the long party. Traditionally, hedge funds have used TRSs for three principal purposes, among others. First, hedge funds have used TRSs to gain economic exposure to companies without obtaining beneficial ownership of the stock of those companies, thereby avoiding the obligation to file a Schedule 13D and preserving the secrecy of incipient activist campaigns. Second, offshore hedge funds have used TRSs to obtain economic exposure to dividend-paying U.S. stocks while avoiding the 30 percent withholding tax typically imposed on dividends paid by U.S. public companies to non-U.S. persons. Offshore hedge funds have been able to use TRSs to avoid such withholding tax because, until recently, dividends were subject to withholding but “dividend equivalent payments” – the amount paid by a financial institution to a hedge fund under a swap by reference to the dividend paid by the relevant equity – were not. Third, hedge funds have used TRSs to obtain leverage. That is, the traditional way to get exposure to the total return of a stock was to buy it. However, TRSs enable hedge funds to get exposure to the total return of a stock by entering into a contract with a financial institution and posting initial and variation margin (which, even taken together, often constitute only a fraction of the market price of the stock). The first two of those purposes have been dramatically undermined by judicial and legislative action. Specifically, with respect to the use of TRSs in activist campaigns, in June 2008, the U.S. District Court for the Southern District of New York held that two hedge funds that had accumulated substantial economic positions in publicly-traded railroad operator CSX Corporation, principally via cash-settled TRSs, were deemed to have beneficial ownership of the hedge shares held by their swap counterparties. Accordingly, the court found that one of the hedge fund group defendants, The Children’s Investment Fund Management (UK) LLP and related hedge fund and advisory entities, violated Section 13(d) of the Securities Exchange Act of 1934 by failing to file a Schedule 13D within ten days of the date on which its beneficial ownership exceeded five percent. See “District Court Holds that Long Party to Total Return Equity Swap May be Deemed to have Beneficial Ownership of Hedge Shares Held by Swap Counterparty
,” Hedge Fund Law Report, Vol. 1, No. 14 (Jun. 19, 2008). With respect to the second purpose described above, in January of this year, the IRS issued an industry directive (Directive) outlining TRS structures that, in the agency’s view, may be used to improperly avoid withholding tax on dividends. See “New IRS Audit Guidelines Target Equity Swaps with Non-U.S. Counterparties
,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010). More recently, on March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment (HIRE) Act (H.R. 2847), which contained provisions originally proposed as part of the Foreign Account Tax Compliance Act of 2009. See “Bills in Congress Pose the Most Credible Threat to Date to the Continued to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains
,” Hedge Fund Law Report, Vol. 2, No. 52 (Dec. 30, 2009). Among other things, the HIRE Act will impose a 30 percent withholding tax on dividend-equivalent payments made to non-U.S. persons on or after September 14, 2010 on certain TRSs or pursuant to securities loans and “repo” transactions. While there is significant overlap between the TRSs targeted in the Directive and those for which withholding will be required under the HIRE Act, the HIRE Act covers a broader range of TRSs. While the third purpose of TRSs identified above – providing leverage – remains reasonably intact, the CSX
case, the Directive and the HIRE Act collectively challenge the utility of TRSs for hedge funds, pose unique structuring challenges and change market dynamics that have existed for 20 years. Yet the Directive and HIRE Act may also, like other facially adverse actions or events, offer opportunities. With the goal of helping hedge fund managers navigate the changing tax consequences of TRSs, this article describes: the mechanics of TRSs in greater depth; the business benefits and burdens of TRSs; the Directive, including the specific scenarios identified by the IRS as meriting further attention from field agents; the relevant provisions of the HIRE Act; the likely market impact of the Directive and HIRE Act, including the specific impact on financial institutions, master-feeder hedge fund structures and TRSs written on a “basket” of equities; and potential structuring alternatives to avoid the adverse tax consequences of the Directive and HIRE Act.