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