Did the Commodity Futures Trading Commission miss the mark in accusing the Royal Bank of Canada with operating a massive wash trading scheme to earn millions in illicit tax breaks?
The CFTC filed a lawsuit against RBC earlier this week, alleging that for nearly three years the Canadian bank illegally traded hundreds of millions worth of single stock and stock index futures. The regulator's complaint said a small group of senior RBC executives orchestrated the scheme, which enabled the firm to allegedly profit from buying and selling futures in OneChicago LLC and CME Group without taking an actual position in the market.
"RBC's futures trading was conducted in a riskless manner that ensured that the positions, profits and losses of each RBC counterparty was washed to zero in disregard of the price discovery principles of the futures markets," the CFTC said in a statement.
The regulator added that the scheme was part of an overall strategy by the bank to earn lucrative Canadian tax benefits from holding certain public companies' securities in both its Canadian and offshore trading accounts. RBC subsequently denied any wrongdoing and dismissed the charges as absurd. But the company is also not alone in its view that the CFTC was off target in launching its case.
"This was not a wash sale in the sense of the 1921 Revenue Act," said George Michaels, the founder of tax compliance software provider G2 FinTech. " From the description provided by the Wall Street Journal, the RBC technique seems to involve a hybrid of a tax straddle and a dividend farm."
A tax straddle is most commonly used in futures and options trades as a way to earn tax benefits. In order to make money using this technique, an investor who earned a capital gain takes a position that actually creates an artificial loss in the current tax year, and postpones their gain to the next.
A dividend farm, Michaels explains, is when an investor simultaneously goes long and short in two securities with similar risk profiles as a way to convert ordinary income into qualified dividend income. In this case, RBC likely found it desirable to flip its ordinary income into qualified dividend income due to the way Canadian taxes are structured, Michaels points out.
Under Canadian tax law, dividends are taxed at 19 percent, a much lower rate than the nation's 29 percent tax on ordinary income. On top of that is a provincial tax that ranges between 10 and 19 percent, Michaels adds.
But even if RBC may not be guilty of wash sales, Michaels points out that U.S. companies are barred by the nation's tax laws from executing a dividend farm scheme or a tax straddle. The Internal Revenue Service would also never allow that sort of tactic to take place.
"They're using more and more sophisticated software each year to detect and shut down anything that even remotely resembles a riskless transaction," Michaels says. "Even if the intent was to take risk, the IRS takes the position that if it 'appears' to be riskless, the tax shelter laws kick in and the deduction is denied."