People close to the investigation said prosecutors were examining what role Deutsche Bank and its clients played in controversial “dividend arbitrage” trades that have been used by a wide range of financial firms and investors to reduce taxes on stock dividends by taking advantage of loopholes in European tax law.
The German prosecutors have been focused on a type of dividend-arbitrage strategy known as “cum/ex,” which were done using dividend-paying shares, the people said. The strategy has been employed using shares issued by companies in Germany, Austria and a handful of other countries. Other legal battles have played out, including in Switzerland, tied to tax refunds paid by their governments stemming from dividend-tax trades.
* * * *
The term “cum/ex” refers to the timing of the transactions around dividend payments, when the market value of the shares declines after the dividend is no longer factored into the price.
In past years, investment firms and banks used the carefully coordinated cum/ex trades to claim rebates on withholding-tax payments despite not having actually paid such taxes in the first place, according to market participants, lawyers and others familiar with the trades.
* * * *
The market for German cum/ex trades largely died off in 2011, when tax authorities closed loopholes and exchange officials fine-tuned how they handled certain transactions, making the trades less-profitable. Cum/ex trades continued on a smaller scale in other countries, but have subsided, market participants say.
Deutsche Bank was among a number of active cum/ex market participants for several years and employed some traders who went on to start funds specializing in the trades, according to traders and brokers familiar with the transactions and trading documents reviewed by the Journal. The bank provided financing for some clients to carry out the strategy, including with asset-management firms that catered to wealthy individuals, the market participants said.
Other European and global banks were also active in cum/ex trades, helped by close relationships with wealthy European investors and fund managers geographically located to take advantage of quirks in tax rules. A Deutsche Bank spokesman didn’t comment on the bank’s past cum/ex activity.
German prosecutors and tax authorities have been pursuing a yearslong investigation of cum/ex trades, alleging that firms fraudulently obtained hundreds of millions of dollars’ worth of tax benefits. German authorities have sought help from other European governments, including in the U.K., to gather information about specific trades and clients, the Journal reported last year.This sounds like a variation of the bullshit tax shelter involved in Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001), here; and IES Industries, Inc. v. United States, 253 F.3d 350 (8th Cir. 2001), here. The courts in those cases blessed the bullshit tax shelters. Here, however, is what the Federal Circuit recently said about those holdings in Salem Financial, Inc. v. United States, ___ F.3d ___ (2015), here:
The transactions at issue in Compaq and IES involved an almost simultaneous purchase and sale of the securities in question; the purchase price was greater than the sale price by the amount of the dividend received by the taxpayer after foreign taxes on the dividend. The transactions therefore did not meaningfully alter the taxpayers' economic position (apart from their tax consequences); they involved essentially no risk (other than the risk that the transactions would be disallowed for tax purposes); and they offered no opportunity for economic gain (except for the tax benefits). Because of the fees paid in connection with the transactions, the consequence of the transactions, but for the foreign tax credits, would have been a certain loss. Thus, the transactions relied for their profitability entirely on the availability of a U.S. foreign tax credit for the taxes paid to the foreign government.
The Compaq and IES transactions produced no real economic profit. The taxpayer incurred a loss from the sale of the securities in the amount of the dividend, net of the foreign tax. Any apparent profit from the transactions was the result of offsetting that loss by the amount of the dividend, without taking into account the foreign taxes paid on the dividend. And the fact that the transactions produced a net gain to the taxpayer after taking both the foreign taxes and the foreign tax credit into account says nothing about the economic reality of the transactions, because all tax shelter transactions produce a gain for the taxpayer after the tax effects are taken into account -- that is why taxpayers are willing to enter into them and to pay substantial fees to the promoters. n6 The critical question is not whether the transaction would produce a net gain after all tax effects are taken into consideration; instead, the pertinent questions are whether the transaction has real economic effects apart from its tax effects, whether the transaction was motivated only by tax considerations, and whether the transaction is the sort that Congress intended to be the beneficiary of the foreign tax credit provision.Readers' comments will be appreciated.
n6 Academic commentators, sometimes referring to the transactions at issue in those cases as a form of "foreign tax arbitrage," have argued that the transactions should have been disregarded as lacking in economic substance. See Bryan Camp, Form Over Substance in Fifth Circuit Tax Cases, 34 Tex. Tech. L. Rev. 733, 752-53 (2003); Mitchell Kane, Compaq and IES: Putting the Tax Back in After-Tax Income, 94 Tax Notes 1215, 1217 (Mar.4, 2002); Michael S. Knoll, Compaq Redux: Implicit Taxes and the Question of Pre-Tax Profit, 26 Va. Tax Rev. 821,840 (2007); Michael J. McIntyre, A Vote in the Compaq Debate, 94 Tax Notes 1716 (Mar. 25, 2002); Daniel N.Shaviro and David A. Weisbach, The Fifth Circuit Gets It Wrong in Compaq v. Commissioner, 94 Tax Notes 511(Jan. 28, 2002); George K. Yin, The Problem of Corporate Tax Shelters: Uncertain Dimensions, Unwise Approaches,55 Tax L. Rev. 405, 407-13 (2002). Professors Klein and Stark argue that the Compaq transaction was not really tax arbitrage, but instead was a form of economic arbitrage. Nonetheless, they agree that the absence of risk in the Compaq transaction "may well be an adequate reason for ignoring the transaction entirely." William A. Klein & Kirk J. Stark, Compaq v. Commissioner -- Where is the Tax Arbitrage?, 94 Tax Notes 1335, 1338 (Mar. 11, 2002).