Objectivus Expert Services – Dividend Arbitrage Explainer
This new series of posts delves into the nuances between the two major dividend-related trading strategies that have purportedly cost European taxpayers €150bn over a two-decade period. The articles will separately study each trading strategy, the legal challenges and ongoing litigation, and finally the belated EU-wide policy response eDective from 2030.
Part 1: The Distinction Between Cum-Ex Dividend Arbitrage and WHT Reclaim Schemes
Introduction
Innovation within financial markets has given rise to various tax-driven trading strategies, some of which have led to significant regulatory scrutiny. Among the most extensively litigated strategies in recent history are Cum-Ex dividend arbitrage and withholding tax (WHT) reclaim schemes. Both involve dividend-related transactions and withholding tax refunds, but their mechanics, execution, and legal consequences diDer substantially. Understanding these distinctions is essential for evaluating their impact on financial institutions, tax authorities, and investors, as well as the regulatory and enforcement measures that have followed.
Cum-Ex Dividend Arbitrage
Cum-Ex dividend arbitrage originated in Germany in the 1990s and gradually expanded across European financial markets. The strategy relied on exploiting the interaction between dividend withholding tax regulations and the way stock settlements are processed. In many jurisdictions, a withholding tax is deducted from dividends at source prior to being distributed to shareholders, and certain investors, particularly foreign entities, are eligible to reclaim some or all of this tax under double taxation treaties. Cum-Ex transactions sought to take advantage of the fact that stock ownership records, due to the standard (or deferred) T+X settlement cycle, could be deemed ambiguous, allowing multiple parties to claim ownership of the same shares over ex- dividend dates.
The core mechanism of Cum-Ex involved coordinated trading among multiple entities, including banks, hedge funds, and brokers. These transactions often included short selling, derivative agreements, and stock lending arrangements, structured in such a way that multiple parties appeared to have been the beneficial owner of the same shares over the ex-dividend date. When the dividend was paid, and the tax deducted, multiple tax refund claims were submitted to tax authorities based on a single underlying dividend payment. This resulted in a situation where tax authorities often issued refunds exceeding the actual amount of withholding tax that had been deducted at source from the issuing company.
The distinctive feature of Cum-Ex trading was that it involved bona fide transactions in the equity market, but these transactions were structured to create ambiguity over economic ownership of the right to the dividend payment. Tax authorities, who processed tax refund claims manually, were unable to access and therefore cross-reference ownership records in real time, which added another layer of complexity regarding the identification of the ‘rightful’ owner of the dividend. This ineDiciency of the regulatory/tax environment is developed further in Part II.
WHT Reclaim Schemes
In contrast, WHT reclaim schemes did not rely on share trading dynamics but instead involved the submission of documentation to tax authorities which contained alleged misrepresentations with the sole aim of generating withholding tax refunds. These schemes often involved foreign pension funds, oDshore entities, or investment vehicles that claimed to have suDered withholding tax on dividends, even when no such tax had been paid. In certain instances, documentation was produced to substantiate claims that shares had been held at the time of a dividend distribution when, in fact, legal ownership had never been transferred.
While Cum-Ex transactions were structured around market activity, giving rise to multiple claims on the same dividend payment, WHT reclaim schemes aimed to generate a single claim, based upon an intricate structure of equity, derivative and stock lending trades. These schemes frequently involved networks of financial institutions and intermediaries, including custodians and brokers, who provided the necessary documentation to support the claims. In Part II we elaborate on the WHT Reclaim schemes and the legal challenges they face.
Legal Interpretations of Each Strategy
Authorities across Europe have taken legal action against both Cum-Ex and WHT reclaim strategies. The Cum-Ex, Cum-Cum and WHT reclaim trading is responsible for an estimated €150 billion in tax losses over two decades.
However, the legal arguments and regulatory focus diDer in each case. Cum-Ex cases often revolve around whether the transactions constituted legitimate tax arbitrage or deliberate manipulation of tax laws, while WHT reclaim cases tend to involve allegations of outright fraud due to the submission of alleged false documentation.
The distinction between the two is critical in legal proceedings, as it aDects how courts assess the intent behind the transactions and the extent to which participants can be held liable. In both cases, regulatory scrutiny has increased substantially, leading to widespread litigation and eDorts to recover tax losses incurred by European governments.
In the next instalment of this three-part article, we delve into the litigation processes which started in the latter half of the 2010’s, highlighting the retrospective nature of the claims and the subsequent rulings that have been made.