Tax Rate Arbitrage

One of my favorite new categories of special situations is “tax rate” arbitrage.

Here’s an example. Let’s assume company XYZ is trading at $10 and will be paying a special dividend of $6.

  1. Buy XYZ for $10 and you must hold for 61 days (including date of div) for div to be qualified (15% tax rate).
  2. Receive a $6 dividend. Tax on the dividends will be 15% or $0.90.
  3. Sell RemainCo once it drops from $10 to $4.
  4. Capture the short-term capital loss of $6. The tax credit will be 35% or $2.10.

Total After-Tax Return: 11.2%

11.2% = (5.10 + 2.10 + 4) / 10

What is even cooler is when RemainCo looks undervalued. This brings me to my case study: ECN Capital. In August ’21 a Google alert notified me that ECN Capital would be paying a special dividend once it’s completed the sale of a major division. Expected timing: December ’21.

It looked really interesting. At the time of the division sale announcement (August ‘21) ECN was trading at $10.65. So RemainCo (net of $7.50 div) was trading at $3.15. Management had issued RemainCo EPS guidance of 0.25-0.30 so it was trading at a PE of 11x. This seemed like a very cheap multiple for the remaining specialty finance business which was growing rapidly.

Credit Suisse valued RemainCo at $5.50 which seemed fair. So I added ECN to my watch list and continued to follow it.

In November ’21 after management had confirmed multiple times that the transaction remained on track to close in December, I bought the stock. In December ’21, the sale closed and ECN paid out its 7.50 div. Post the dividend, ECN opened at $5.31 (pretty close to Credit Suisse’s estimate of fair value). I had to wait 61 days to sell to retain qualified status on my dividend, but on February 1, I sold at $5.33 for a 19.4% after tax return in 61 days. 

19.4% = ($2.86 (after-tax div) + 4.14 (return of capital) + 5.33 (sale price) + 0.39 (ST tax loss credit) ) / 10.65 (purchase price)

The calculation is a little complicated because 45% of div was considered a return of capital and 55% was considered a special dividend) 

There are some caveats:

  • Strategy only works for US investors (although there could be a similar strategy in other countries!)
  • To take advantage of this trade you need to have ST gains (however, losses can be retained to offset gains in future years)
  • I’m not a tax advisor

One final comment: Before I put on this trade, I shared it with my premium subscribers (that’s my policy).

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