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Podcast: Cum-Ex Dividend Trade Investigations

Time to Listen: 20:07 Practices: Tax, Tax Controversy, Executive Compensation & Employee Benefits, Asset Management, Banking

In this Ropes & Gray podcast, Alec Oveis, an associate in the tax and benefits group is joined by Kat Gregor, a partner in the tax group and co-founder of the tax controversy group, and Andy Howard, a partner in the tax group, to discuss the investigations now underway in Europe involving so-called “cum-ex dividend trades.”

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Alec OveisAlec Oveis: Hello, and thanks for joining us today on this Ropes & Gray podcast. I’m Alec Oveis, an associate in the tax and benefits group. Joining me are Kat Gregor, a partner in the tax group and co-founder of the tax controversy group, and Andy Howard, a partner in the tax group.

We’ll be discussing the investigations now underway in Europe involving so-called “cum-ex dividend trades.” The stakes involved in these investigations are quite large, especially for banks, asset managers and brokerage firms. There are perhaps billions and billions of euros in lost tax revenue that investigators and prosecutors are now looking to recover. Many of Europe’s most recognizable and well-known banks are being asked to cooperate in investigations and provide records of transactions; search warrants have been issued and executed; and in at least one case, a bank has been found liable for millions in unpaid taxes.

Yet, this only scratches the surface. A recent report published by a group of news organizations described this as “the biggest tax swindle in the history of Europe.”

These investigations are not solely affecting banks and taxpayers based in the UK and Europe: EU-based offices of U.S. firms are also being asked to participate and provide documentation when requested. In addition, one country, Denmark, has already taken action to collect against taxpayers based in the U.S. As a result, U.S. asset management firms and financial institutions have a significant stake in these investigations.

Before we discuss the transactions at issue and the investigations, Kat, can you discuss why U.S taxpayers may be concerned, more broadly?

Kat GregorKat Gregor: Thanks, Alec. First, as you mentioned, the local, EU-based offices of U.S. firms are being asked to cooperate and provide records. We’ve seen this already in a few cases, where European authorities have made formal requests of major U.S. firms to provide trading records. It’s worth underscoring that there may be nothing nefarious here – that the banks themselves, or their employees, were not active participants in these trades. Still, the expectation from European authorities is that firms will cooperate and be forthcoming with information.

But second, the enforcement actions are spreading outside the European jurisdictions themselves. SKAT, the Danish tax authority, has brought lawsuits against hundreds of U.S.-based pension plans that are alleged to have improperly benefited from these dividend withholding tax refunds. While these cases were brought in various federal district courts around the country, they have been consolidated into a single multi-district litigation, or MDL proceeding, in the Southern District of New York.1

Alec Oveis: Are U.S. banks and asset management firms themselves – apart from their local, in-country offices – at risk?

Kat Gregor: So here, things may be a bit more complicated. While the banks themselves have not yet been directly implicated in U.S. courts, the litigation to recover proceeds of the alleged fraud (as Andy will discuss in a moment) may pull banks in to the extent they participated in, facilitated or otherwise have records relating to the transactions at issue. This could come both as a result of litigation discovery (for example, the banks are asked to hand over records in a potentially public forum), and, if they did actively participate in the trades, they could face exposure of being pulled in as an additional, later-named defendant or even being implead as jointly liable by the existing defendant. 

Alec Oveis: Thanks, Kat. Turning to the transactions themselves in more detail, Andy, could you provide some context into cum-ex dividend trades? What is dividend arbitrage?

Andy HowardAndy Howard: In essence, dividend arbitrage trades rely on the fact that many jurisdictions, particularly in continental Europe, impose high levels of dividend withholding tax. However, they frequently reduce those rates for some shareholders, for example, pension funds in treaty territories. Dividend arbitrage transactions involve transferring the shares or the dividend rights over the dividend record date from a high-rate taxpayer to a low-rate taxpayer. The low-rate taxpayer will bear varying degrees of risk in relation to movements in the stock, often limited risk. In many jurisdictions, the withholding tax system works through withholding and repayment rather than relief at source. So, in that transaction, the low rate tax payer will hold the share over the dividend date and will be able to reclaim a repayment of the withholding tax.

Shares can be transferred and risks can be allocated using an array of complex financial instruments including stock loans, forward sales, total return swaps and others. A feature of many of these instruments is that they involve the payment of dividend equivalents, or manufactured dividends, as they are sometimes called. Tax authorities have struggled with the appropriate way to tax manufactured dividends.

Generally speaking, most dividend arbitrage transactions have been accepted as sensible tax planning. Some jurisdictions, however, have challenged whether the temporary holder at the dividend date is actually the beneficial owner of the relevant dividend or they’ve sought to challenge some transactions under anti-abuse rules. The French senate proposed new anti-avoidance rules in this area.

Alec Oveis: And a cum-ex transaction is a type of dividend arbitrage trade?

Andy Howard: Yes, it can be described as an aggressive dividend arbitrage trade. The key feature of a so-called cum-ex transaction is that Party A agrees to sell Party B a share carrying the right to a dividend payment (“cum div”) but in fact it settles the transaction with stock, which no longer carries the dividend entitlement (“ex div”). Party B who receives the ex div stock is therefore made whole by a manufactured payment from Party A, which is paid after withholding so is reduced by the withholding amount. In these circumstances, it appears that some jurisdictions had practices which allowed Party B to claim a refund of the withholding tax as if it had actually received dividends. In a simple transaction, there is some logic in this: Party B has incurred the cost of the withholding, even though it is entitled to receive without withholding. The difficulty here is that the express link between the actual withholding tax and the refund claim for that withholding tax has been broken--it is not necessarily the case that Party A owned the actual share and received the dividend. This opens up the possibility that the party that owned the actual cum div share, who may well have had no knowledge of the transaction between Parties A and B, could also have claimed a refund of the withholding tax. And so, potentially, you have multiple parties claiming a refund for a single payment of withholding tax.

Alec Oveis: So, is that what happened in practice?

Andy Howard: It appears so, yes. A number of European tax authorities have identified that the amount they received in dividend withholding tax was actually less than they paid out by way of dividend refunds. From the perspective of those tax authorities, the position is very simple: the system is clearly not intended to work that way, and so they must have been the victims of fraud and should be reimbursed.

Alec Oveis: And, is it that simple?

Andy Howard: I think the question is on what basis do you recover and from whom. In the example we’ve just discussed, Party B made the immediate refund claim, but Party B didn’t benefit economically from the transaction—it was in the same place as if it had held the share and received the dividends --so it is arguably unjust for Party B to suffer the cost. If the cost is imposed on Party B, Party B may think it is appropriate to try and recover from Party A and so on. Or, alternatively, the tax authority could allege that Party A, for example, is the mastermind of the transactions, and presumably had some financial benefit, though this can be very difficult to piece together from the pricing of the various transactions, and so it can cover direct from Party A, even though Party A has not made any tax filings in the jurisdiction.

It would be naive to think that at least some of the participants in the transactions were not aware of, at least, the possibility of duplicative refunds. According to press reports, some individuals are on record as having pointed out the apparent flaw in the system to clients. However, each individual transaction involved a large number of participants, with varying degrees of knowledge of other participants and related transactions, making it quite difficult to distinguish between innocent participants and transactions and less innocent ones.

Alec Oveis: Apart from Parties A and B, could others become involved?

Andy Howard: Participants in a single transaction, in addition to Parties A and B, are likely to have included custodians for both parties. They may have issued the vouchers that allowed the refund claim. It may also have included market participants who sold the ex div shares to Party A, financial institutions or funds which provided liquidity for the trade or entered into hedging agreements with the various parties. So, quite a lot of parties and in addition transactions would typically have been carried out using standard form documents and market financial terms (sometimes only completed to memorialize trades done over the phone), so the transactions are likely to have been fairly light in terms of documentation, and unlikely to have involved external advisers or transaction-specific approvals within institutions. In addition, records of transactions might be limited and transactions may be difficult to reconstruct from what records are present. In many cases, transactions would have taken place ten or more years ago, and institutions will have had a significant turnover of staff in the interim. As a result, evidence will be a major factor, both for tax authorities trying to establish culpability and for institutions seeking to defend their role.

Alec Oveis: Which jurisdictions are investigating?

Andy Howard: Germany and Denmark are attracting the headlines as being most active. However, France, Spain, Italy, the Netherlands, Belgium, Austria, Finland, Norway and Switzerland are also reported to have been affected.

Alec Oveis: Thanks, Andy. Kat, you mentioned the MDL proceeding in New York, can you provide a status update on where that currently stands?1

Kat Gregor: Sure. Right now, the defendants are actively working to get the entire case dismissed based on a principle in the U.S. tax system called the “Revenue Rule.” Arguments were heard last month on whether the case should go forward, and we are currently awaiting the court’s decision.

The Revenue Rule is a longstanding, general principle of U.S. tax law; and, put simply, the rule is that a U.S. court may not be used to enforce the revenue, or tax, laws of another country. The revenue rule is pretty firmly engrained throughout the U.S. judicial system. The consequence is that a foreign sovereign – say, the Danish taxing authority here – generally can’t enter into a U.S. court and argue that Danish tax laws were violated. That would be a question for Danish courts to determine. Further, foreign sovereigns are typically prevented from using U.S. courts to collect taxes that their courts have otherwise determined are due, unless there is a treaty wherein the U.S. has agreed to assist in the collection of taxes.

From that perspective, if this was just about tax assessment and collection, things seem pretty clear. Yet, SKAT, the Danish taxing authority, is testing out a new theory—namely, they are arguing this is not the enforcement of a tax law, but, instead, a civil lawsuit for damages from fraud. In other words, Denmark is arguing that this isn’t a tax case at all – it’s fraud or theft. From their standpoint, Denmark isn’t trying to collect tax revenue; the defendants aren’t taxpayers; there isn’t a real, substantive connection to the Danish tax system, apart from the fact that this purported fraud was done through a withholding tax refund system. If they successfully argue this, then perhaps the Court will agree that the revenue rule won’t apply, and that could be a game-changer.

Remember Denmark is at the forefront of this. If they get past the motion to dismiss stage, we very well may see a series of other European jurisdictions looking to the U.S. courts to recover these alleged wrongful tax refunds.

For this reason, I suspect a number of other countries are watching closely. Denmark is in effect the test case. It was ahead of the curve on much of this – in detecting these trades and identifying perpetrators. It’s also been willing to try out new legal approaches and to test them out in a U.S. court. My sense is that other countries are in the earlier stages of the investigative process – they’re still gathering information and determining the scope of the issue. And depending on how successful Denmark is, we might see other countries take a more ambitious or more aggressive stance.

Alec Oveis: What sort of advice are you giving clients – whether they suspect employees may be engaged in these trades, or whether they simply have records of trades that may be of interest to prosecutors? How should they try and get ahead of this?

Kat Gregor: Sure well, companies (banks, asset managers and institutional investors) all need to make sure they have a handle on their exposure to this, both historically and from a future, compliance perspective. So, if your organization could have participated in this historically, the first step is to do a deep dive and ascertain whether you have engaged in this type of activity, and understand your total exposure. What countries were affected, how many transactions and what is the magnitude of taxes at issue. Legal, compliance and risk management team members should all be at the table and working in partnership with the business teams to identify possible trades of interest. You should be gathering documents; gather the records; and do an internal assessment of the issue.

And if you don’t have a compliance process already in place to ensure employees are not facilitating these types of transactions going forward, now is the time. Going forward, companies will need to understand the types of trading activity that may trigger a problem like this and implement policies, procedures, and systems to prevent that activity from happening.

Another piece of advice we have given is that if a company has exposure, it should both have a central point of strategy (whether an international external counsel or a member of the GC’s office), but also, be in constant contact with local counsel. Understand the options available in any particular jurisdiction. See if there is a voluntary disclosure or compliance program that may help mitigate the possible consequences, if an employee (or multiple employees) did engage in transactions in the past.

Finally, companies should prepare for the possibility they’ll be pulled into litigation – either directly, or as a third-party defendant. Short of that, they’ll likely be asked to cooperate in investigations. And all of this takes time, effort, and attention – and in my experience, the more that can be done in advance to develop a strong strategy, the better off we all are. And one final piece of advice: pull in your public relations team early. This particular issue is in the headlines, and lately, tax fraud has become a topic of interest in popular media. Developing a strategy that takes into account a media relations aspect can be critical to avoiding long-term reputational damage.

Alec Oveis: Kat mentioned there is already litigation underway in the UK. Andy, what is that litigation about?

Andy Howard: Yes, so going back to something mentioned by Kat, the Danish tax authority, as well as taking on litigation in the U.S., they’ve said that they have opened 388 civil cases against firms and individuals in a number of countries, as well as the U.S. and UK litigation, but also Canada, Malaysia and Luxembourg.

In the UK, the Danish tax authority sued two hedge funds, and 71 other individuals and companies accused of dishonestly receiving tax refunds from the Danish Government, conspiracy to launder and conceal the proceeds of the payments, intending to cause financial loss to the tax agency. It also accused some tax refund companies of having negligently stated that the applications were genuine. And they have had some success in this litigation.

In August 2018, the Danish tax authority requested a default judgment against the two hedge funds because of the defendants’ failure to file an acknowledgment of service or a defense within the time limits set down by the UK's rules. That was granted in September 2018.

Alec Oveis: Are any other parties involved?

Andy Howard: Yes. Illustrating the point I made earlier about the search for evidence, the Danish tax authority also filed a Part 8 claim in March 2018 against two major UK banks and several foreign exchange firms as it sought information to help identify the alleged wrongdoers and the recipients of its money. The court granted an order for the disclosure of documents by innocently involved third parties.

And earlier in November 2018, the Danish tax authority won permission to use material disclosed during the English legal proceedings in litigation elsewhere. The documents were held to be in the public domain, and it was held that there was a strong public interest in assisting the Danish tax authority given the size of the fraud alleged. The Danish tax authority can now use evidence summarizing the information obtained under the Part 8 claim against the two banks I just mentioned.

Alec Oveis: Well, this is very interesting but unfortunately that’s all the time we have for today. Kat, Andy, I want to thank you for sharing these insights. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other important tax developments as they arise. Thank you for listening.

1 Update: On January 9, 2019, Judge Lewis Kaplan of the U.S. District Court for the Southern District of New York denied the defendants’ motion to dismiss In re: SKAT Tax Refund Scheme Litigation.

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