ABUSE OF STRUCTURED FINANCIAL PRODUCTS- Misusing Basket Options to Avoid Taxes and Leverage Limits MAJORITY AND MINORITY STAFF REPORT

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corporation, and are instead treated as pass-through entities for tax purposes. In other words,
taxes owed by the partnership are not paid by the partnership, but are instead passed on to each
individual partner who becomes responsible for paying any taxes owed. Because hedge funds
are not taxed at the entity or fund level, the fund distributes to its investors their proportionate
share of the fund's gains and losses for tax purposes. Investors are required to report the gains or
losses on their individual tax returns based upon the character of the income or gain earned by
the fund. Investors pay taxes on the gains or losses at the short-term capital gains rate if the
investment was held by the fund for a year or less, and taxes at the long-term capital gains rate if
the fund held the investment for more than one year.
(2) Taxation of Stock Dividends
Because basket options involve the trading of securities, another key tax issue involves
the taxation of stock dividends.
Dividends Generally. A dividend is a distribution by a corporation of a portion of its
earnings to its stockholders, with the amount to be distributed based upon the number of shares
held by each stockholder. If the dividend recipient is a U.S. person, at the end of the calendar
year, the recipient must report all dividends received on the recipient’s tax return as part of that
taxpayer’s taxable income. 60 Under the tax code, U.S. stock dividends are treated as ordinary
income and taxed at the ordinary income tax rate, unless they fall into a special category of
“qualified dividends” in which case they are taxed at a 0%, 15%, or 20% rate depending on the
tax bracket of the taxpayer.
Dividend Withholding. Different rules apply to stock dividends paid by U.S.
corporations to nonresident alien individuals or non-U.S. corporations, partnerships, or other
entities (“non-U.S. persons”). Dividends paid to non-U.S. persons that are not connected with a
U.S. business are subject to a tax rate of 30%, absent a tax treaty between United States and the
non-U.S. person’s country of residence setting a lower rate. 61
U.S. tax law also requires the 30% tax to be “deducted and withheld at the source” of the
dividend payment being made to the non-U.S. person. 62 The purpose of this requirement is to
ensure that the tax owed on the dividend payment is withheld and remitted to the IRS, before the
dividend payment leaves the United States, since the United States is generally without authority
to compel collection of U.S. taxes outside of its borders. 63
The tax code’s tax withholding regime for U.S. stock dividends has been in place for
decades. 64 The law requires the U.S. withholding agent to withhold the appropriate amount of
60 Id.
61 See 26 U.S.C. §§ 871(a)(1)(A) and 881(a)(1); 3/27/2014 “United States Income Tax Treaties - A to Z,” prepared
by IRS, http://www.irs.gov/Businesses/International-Businesses/United-States-Income-Tax-Treaties---A-to-Z.
62 26 U.S.C. §§§ 1441(a), 1441(b), and 1442(a).
63 See id.
64 The first federal withholding statute was enacted in 1913; the first comprehensive set of IRS withholding
regulations for nonresident aliens was issued in 1956. See 12/1/2007, “Tax Compliance: Qualified Intermediary
Program Provides Some Assurance That Taxes on Foreign Investors are Withheld and Reported, but Can Be