By Daniel Shin
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Cum-ex (meaning "with-without" in Latin) is a massive stock trading scam. The cum-ex affair is the name given to a huge volume of transactions that involved exploiting a tax loophole on dividend payments that enabled a number of parties to claim the same tax refund. This loophole was technically closed in 2012 although there are still disputes in the courts over whether or not the practice of short selling, the brief loaning of stocks aimed at confusing tax authorities, was ever legal.
Cum-ex trading schemes were first revealed by Correctiv, a German non-profit consortium of investigative journalists who helped bring the scandal to broader public attention. Using German stock trading data, Correctiv noticed much evidence for this type of transaction whereas there was a substantial increase in the number of stocks traded immediately before the ex-dividend dates. It really looked fishy as there were huge increases in over-the-counter transactions, where trades were particularly easy to arrange only between the agreed parties.
The kind of trading is also called dividend stripping. First, banks and stockbrokers rapidly trade shares with and without dividend rights, in a way that enables them to hide the identity of the actual owner. This meant that they could agree to sell a stock before the dividend was paid out, but deliver it after the dividend had been paid. This tactic enabled both parties in the transaction to claim tax deductions even if the tax had been paid only once. Massive trades between various parties could have numerous owners, creating large profits to the brokers.
The bank that was acting as a middleman in stock trading would then issue a confirmation to the multi-layered investors that tax on the dividend payment had been paid while in fact it was actually being done without it. After that, tax lawyers write legal opinions to confirm that everything is treated as legitimate under law. Armed with this confirmation, the investors would then be eligible for tax reimbursement. Foreign investors were particularly able to claim a refund on such taxes.
There have been many European countries suffering an estimated loss of 55 billion euros in total. And the loss could grow. Cum-ex has triggered the biggest tax investigation seen so far in 11 EU member States so far.
Tax is important to a structured financial transaction because the transaction itself is designed to produce particular returns and also much needed tax-savings to those involved. However, tax can easily scupper a structured financial transaction when the issuer faces a significant tax burden. Particular jurisdictions and taxation regimes can be involved, but tax neutrality in this type of transaction has never been easily assumed. There can be a tax risk for both issuers and holders of a structured financial product. Therefore, tax implications are essential to the viability of any structured financial transaction.
The use of withholding taxes opens opportunities for tax fraud. However, the statutory bearer of the tax may be entitled to a tax refund even if no withholding tax has been remitted. Investors have increasingly used the instrument of withholding taxes to evade dividend taxation, employing cum-ex transactions around the ex-dividend date of a stock. The heart of the issue is that tax loopholes can easily evolve around any type of innovative corporate finance technique.
It is harder to trace especially when it comes to cross-border corporate financial transactions and is hidden under multiple corporate shells. Tax authorities often become aware of such scenarios too late and have no idea what is really going on until the problem is too big to be remain unnoticed.
Here is why tax authorities should care.
First, tax differences are real. They provide a quasi-arbitrage opportunity whenever the investment bankers and tax advisors cleverly structure a new corporate finance scheme in consideration of tax avoidance ahead of the curve.
Second, scale matters. It is often undermined by tax authorities, if the structure is way too complex, but the amount is still small and unnoticeable. Regulatory watchdogs or investigative journalists often dig in first before tax authorities if the matter is significant, regardless of its size.
Third, tax authorities' systematic understanding of how value creation is done in a business context is often missing. Merely knowing the rules is not enough when it comes to complex business decision-making on global scale operations, market expansions, and corporate finance transactions.
Dividend stripping is a form of tax avoidance and it occurs when what should have been a taxable dividend is converted into a capital sum in the hands of a shareholder. It can be structured as a sale of shares to another party, but the ultimate economic ownership or control of the company remains unchanged.
And yet there remains a lack of understanding of the genuine commercial motivation for this type of capital transaction by tax authorities.
The tax loopholes from cum-ex corporate finance transactions may be but the tip of the iceberg. It is well demonstrated that existing tax systems could suffer again from this type of tax loophole in association with other emerging corporate finance techniques.
Daniel Shin is a venture capitalist and senior luxury fashion executive, overseeing corporate development at MCM, a German luxury brand. He also teaches at Korea University.
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