Last Thursday’s FT carried an intriguing story about a German tax avoidance scheme with €billions at stake: the so-called “cum-cum” dividend-stripping device. While we generally think of the Germans as highly disciplined, this looked like an example of complete chaos. And the aggressive artificiality of the scheme took me back to the dark ages of 1970s tax avoidance as peddled by Rossminster. So I decided to dig a little deeper.
The scheme is designed to get round the fact that dividends paid by German companies suffer a 25% withholding tax, which a foreign investor is unable (or only partially able) to re-claim. So the foreign investor (say a financial institution) would team up with a German company (say a bank) who was able to use the tax credit.
Typically the two parties would enter into a stock-lending arrangement, where the shares are loaned to the German resident company for a short period over the dividend payment date. The foreign investor receives a stock-lending fee amounting to, say, 95% or 90% of the gross dividend. The German bank receives the net dividend but is also entitled to the tax credit, which it can reclaim or offset against other income. A simple case is illustrated with numbers at the end of this article. The bank and foreign investor effectively share the benefit of the tax advantage.
These schemes were stopped with effect from 1 January 2016, by introducing a requirement for stocks to be held for 45 days before the holder was entitled to reclaim or offset the tax credit.
The question now is: how should the German government deal with schemes that had already happened?
There are two legal avenues available to challenge the arrangements. First, there’s an argument that beneficial or economic ownership of the stock never really passes to the German bank, so it is never really entitled to the dividend and hence is not entitled to the tax credit. Second, if that argument fails, there is the argument that the scheme is an abuse of law, and should therefore be taxed according to economic reality (so the stock-lending arrangement would simply be ignored).
In a recent case, the Federal Finance Court held (in an August 2015 judgment, published in January 2016) that the first of these challenges succeeded, so the second didn’t need to be considered. The court regarded the arrangements as so artificial, with no economic benefits or risks passing to the stock-borrower other than the supposed tax advantage, that beneficial/economic ownership did not pass to the borrower. Hence the borrower had no entitlement to the tax credit.
The judgement was followed by press investigations into the scale of the dividend-stripping problem, with stories emerging in May (including Washington Post) about the €billions of German tax involved. The political reaction, led by Gerhard Schick, Green party finance spokesman, and Norbert Walter-Borjans, SPD Finance Minister of North Rhine-Westphalia, was given added piquancy as one bank prominently featuring in the headlines, Commerzbank, was bailed out during the financial crisis and is still 15%-owned by the German state.
The Federal Finance Ministry waited until 11 November to issue a statement on how the court ruling would be applied in other cases. And the statement seems to have increased uncertainty rather than resolving it.
The Finance Ministry added its own gloss to the factors that determined the court’s decision, and also covered off the abuse of law argument, saying that the key test for whether dividend-stripping arrangements succeeded was whether they produced a “profit before tax”. Unfortunately, gave no examples to explain exactly how the profitability test would be calculated, and according to Prof Christoph Spengel of Mannheim University (paywall, in German) this lack of clarity has led to diametrically opposed interpretations.
The obvious interpretation of “profitable before tax” is that the calculation should be based on the net dividend, excluding the tax credit. On that basis, the example below would show a loss of 15, and virtually all dividend-stripping arrangements would fail to work – leading to significant tax bills for many German banks. On the other hand, according to Prof Spengel, there have been claims by lawyers, by the banks themselves, and even by the Frankfurt Regional Tax Office, that the calculation should be based on the gross dividend – resulting in a profit of 10 in the example below. On this second interpretation, virtually all dividend-stripping arrangements would work and the scheme would cost the German exchequer €billions.
The Ministry’s statement has also caused political consternation. In early December a conference of Finance Ministers from each of the German Länder voted by 10 to 5 to ask for further clarification. In the interim, while the statement remains on the Finance Ministry’s website, in Prof Spengel’s view it cannot be relied upon given the vote against it – indeed he likens Germany to a “banana republic” on this issue.
Can any conclusions be drawn from this chaos? At present the situation in Germany is still in flux, pending further clarification. But two aspects are striking.
Firstly, the relationship between the Länder (who collect federal as well as state taxes) and the federal government can be a source, not only of delay, but of confusion, disarray and uncertainty in the German tax system. This is quite unfamiliar from a British perspective, and salutary lessons could be drawn from the German experience for any further moves towards tax devolution in the UK.
Secondly, the arrangements are so contrived and circular – reminiscent of schemes seen in the UK back in the 1970s – that it’s tempting to ask why they haven’t been tackled before now, given the arguments available to challenge them. Equally, why did it take until 2016 for them to be decisively blocked by legislative change? By contrast, it’s worth noting that a UK loophole potentially allowing banks to create losses by dividend-stripping was blocked in 2006 before it got fully off the ground, demonstrating the benefit of rules introduced in 2004 requiring the disclosure of tax avoidance schemes.
Suspicions have been aired in the German press that the government’s failure to chase banks for the money lost to these schemes is an informal way of supporting an ailing German banking sector. If so, an interesting question is whether this could be open to investigation by the European Commission as potentially illegal state aid.
A final question is whether the German system of withholding tax on dividends, ostensibly discriminating against foreign shareholders, is compatible with European law. Having seen first-hand the legal challenges, both in the CJEU and our own courts, to the old UK system of Advance Corporation Tax, and the constraints of EU law in designing policy changes, I find it difficult to see how it can be.
[For more on this topic, see my recent article in AccountingWEB: Germany’s big tax scandal: lessons for the UK.]
Together the two parties have received a total of 90 + 7 = 97, compared with the 75 if the scheme had not taken place. The tax saving is 22, and they have effectively shared this between them, with 7 going to the bank and 15 to the foreign investor.