With Cum-Ex investigations in a number of countries gathering momentum, an increasing number of individuals and financial institutions are likely to come under scrutiny. Their response to this will be vitally important.
Cum-Ex was a series of trade strategies which were designed to allegedly exploit tax differences across Europe. This was an arrangement where private investment holding companies and finance companies were organising double refunds of tax that had been paid on one dividend pay-out. The aim was to take advantage of credit to which there was no entitlement.
As a result of these trades, there are now active investigations in various European jurisdictions, including (but not limited to) UK, Germany, Denmark and Austria.
As such, there were no perceived risks involved at the time - only profit. Cum-Ex was one of the most lucrative models in recent years. There were no provisions put in place by European states to prevent Cum-Ex until it came to a head in 2012.
This is a guide for corporate bodies which will set out the following:
Cum-Ex is the name given to a huge volume of dividend trading strategies (dividend arbitrage stock trading transactions) that took place largely prior to 2012. The controversial practice involved exploiting a loophole on dividend payments to trade shares in a way that concealed the identity of the owner and enabled several parties to claim multiple tax refunds for the same dividend pay-out. It has also been known as dividend-stripping.
Germany is the country at the heart of the scandal and the country whose investigations into Cum-Ex are most advanced. The German authorities have claimed that Cum-Ex has cost the country approximately €30 billion in lost revenue. However, various other EU treasuries have also been affected, with some estimates of €55.2 billion being lost in tax revenue as a result of such schemes.
The Cum-Ex scandal is now a rapidly-widening cross-border tax fraud probe affecting many financial institutions and individuals across 11 EU jurisdictions; with investigators engaging in regulatory, civil and criminal proceedings against those involved.
Cum-Ex is an example of a dividend withholding tax (WHT) refund model. Cum-Ex entitled overseas investors in domestic companies to obtain a refund on shares under double taxation treaties. It is worth noting that the UK does not use WHT, so the UK tax authorities are not affected by Cum-Ex transactions, unlike many other states.
Cum-Ex trading began when a tax loophole was discovered in the 1990s. The loophole was utilised by a network of institutions and professionals, including traders, investors, tax advisers, lawyers, brokerage firms and banks. It was a lucrative trading practice until legislative changes were introduced in 2012.
Put simply, banks and stockbrokers rapidly traded shares with (cum) and without (ex) dividend rights, in a way that enabled them to hide the identity of the actual owner. This meant that they could agree to sell a company stock before the dividend was paid out, but then deliver it after the dividend had been paid. This tactic enabled both parties to claim tax rebates of WHT on capital gains tax (a tax that had only been paid once, if at all) from EU tax authorities.
Rapid trading between the various parties could confuse the tax authorities regarding beneficial ownership of the shares, by creating an appearance that the shares were short sold (selling when the seller does not yet hold them) prior to the dividend record date (cum-dividend), when in fact they were sold after the dividend record date (ex-dividend).
Three or more entities are needed for a successful Cum-ex scheme. A simplified summary example is outlined here:
While the above is a simple example, the reality is that Cum-Ex involved a highly complex network of entities providing liquidity and services essential to its operation.
Hedge funds and their Chief Investment Officers (CIO’s) would develop and create strategies for investments relating to Cum-Ex trades. This could involve incorporating companies in various jurisdictions with the purpose of investing in certain listed securities. The hedge fund would create relationships with prime brokers, custodians and banks. The investments would be funded through private equity and leverage provided by prime brokers. The global strategy was likely to involve obtaining a legal opinion approving such investment activities.
Cum-Ex transactions commonly involved four trade legs:
Several parties were essential to the transactions, including finance and stock lending providers. Access to liquidity in both the cash and the forward market was essential.
Each trade leg required a professional intermediary, including:
Ownership of the shares was impossible to ascertain, given the speed of the transactions. The timing of the shorts and dividend compensation payments had the effect of essentially muddying the true beneficial ownership of the stock (shares).
Cum-Ex trading allowed two parties to appear to be the beneficial owners of the same shares, creating the opportunity for multiple WHT refunds on the same dividend payment. Any examination of the beneficial ownership of shares is likely to focus on whether beneficial ownership was actually transferred.
In the context of Cum-Ex transactions, beneficial ownership of the shares and the rights this carries includes:
The Cologne tax court held that under German law, in the case of an over-the-counter short sale, the share purchaser would not become the beneficial owner of the shares to be delivered at a later stage at the settlement of the purchase agreement.
In the UK, the issue of beneficial ownership of shares was addressed in J Sainsbury Plc v O’Connor , in which Millett J said beneficial ownership was “more than equitable ownership. It requires more than the ownership of an empty shell bereft of those rights of beneficial enjoyment which normally attach to equitable ownership.’’
It is imperative that a defence strategy tailored to the needs of the situation is devised the moment it is anticipated that the authorities may take an interest in investigating a corporate body and /or its officers. In our experience, any defence will be dependent on the different trading strategies that were executed by the corporate bodies and the roles that were undertaken by CIO’s and their teams.
Generally, most dividend arbitrage transactions at the time were considered sensible and legal tax planning. Those involved in the Cum-Ex transactions are sure to raise the point that the practice was not illegal or dishonest, and was actually typical market behaviour. The strategies deployed were market neutral. In many cases, companies relied on advice from their lawyers and accountants, and would argue that they did nothing more than see an opportunity due to the ambiguity of the law surrounding this area. Furthermore, it is a practice that had arguably been accepted by legislatures in some EU states, as they had known about Cum-Ex for many years and took no early action.
Corporate bodies (and individual parties) embroiled in Cum-Ex will, no doubt, have their own specific justifications for the practice. For example, they may state they had no responsibility over - or limited knowledge of - the overall strategy and the counterparties involved, with the understanding that all parties had applied their own robust legal and tax advice.
Many UK-based financial institutions were involved in dividend arbitrage at the time, whether that be through equities trading, brokerage or in ancillary roles. Participants in the Cum-Ex trades, such as hedge funds, would purchase substantial amounts of shares in order to make a profit. Due to the borrowing facilities provided by UK prime brokers (who offered services such as financing, securities lending and overdraft facilities), CIO’s or portfolio managers of hedge funds would be able to negotiate and leverage substantial borrowing terms. As a result, the relationships and agreements between these parties could now face scrutiny by the authorities. In our view, this is one of the many reasons why European investigations may well now have a particular focus on London. Investigations have already led to two former London traders being convicted in March 2020 of tax fraud in Germany – in what was the first criminal trial relating to Cum-Ex trades.
Authorities in EU member states may well obtain evidence from the UK authorities to assist in criminal investigations. This process is governed by the Criminal Justice (European Investigation Order) Regulations 2017 (the 2017 regulation). It is essentially a request for sharing evidence in criminal investigations through mutual legal assistance.
The requests are generally made to the Home Office. But for investigations relating to tax and fiscal customs matters the requests are sent to HM Revenue and Customs (HMRC). The issuing authority in a European country will make an application to HMRC, explaining that an offence has been committed or that there are reasonable grounds for suspecting that an offence has been committed. The application will include the names of the subject of the request, the operation name and the reasons why a European Investigation Order is sought.
An order following such an application will only be made if it is necessary and proportionate to make it for the purposes of the investigation or the proceedings in question. A designated public prosecutor in England and Wales will then validate an order pursuant to s7 of the 2017 regulation once the above conditions are satisfied.
In the UK itself, the Financial Conduct Authority (FCA) has been conducting a review into the practices of some firms involved in dividend-stripping trades in Germany. The FCA has confirmed it is currently investigating financial institutions and individuals implicated in the scandal. With the passage of time, there are now extensive numbers of Cum-Ex-related criminal and civil investigations ongoing, as well as significant amounts of litigation. It is highly likely there will be more in the near future.
The full extent of how the Cum-Ex scandal is affecting the UK is, therefore, still yet to be seen.
Financial institutions involved with dividend arbitrage could be at risk of a number of consequences of Cum-Ex investigations. These include both civil and criminal sanctions and the reputational effect that either of these can have upon a firm.
Firms will be subject to FCA requirements, the Money Laundering Regulations 2017 and any legislation preceding this, depending on the period of alleged offending. In addition to this, firms may well be subject to EU Market Abuse Regulations (MAR). Financial institutions will need to have adequate and considered systems and controls in place to satisfy AML requirements, including due diligence on clients/transactions. Firms who are concerned about their exposure should consider conducting an internal investigation and be prepared to self-report anything untoward to the FCA and, possibly, the German authorities.
It is highly likely that European enforcement agencies will target financial institutions, in particular those with substantial resources. This is so that significant financial penalties can be agreed; depending on how corporate bodies are perceived by investigators and what investigations discover about those bodies’ activities. Depending on the merits of the case, a corporate body will need to carefully consider a robust defence and/or remediating measures in order to limit reputational harm.
Rahman Ravelli was one of the very first UK law firms to recognise the possible legal implications of Cum-Ex and its potential impact on all levels of the financial services industry. As a firm that prides itself on a rapid response to the needs of existing or potential clients, we compiled a team of specialists in anticipation of a Cum-Ex caseload. That caseload continues to grow – and our experts are on hand to manage each and every aspect of such cases.
Aziz’s success in some of this century’s most notable financial crime cases and his robust, incisive defence of clients mean he is viewed by legal guides and the profession itself as one of the elite international solicitors handling large-value, high-profile investigations. He is a solicitor who has set legal precedents.
His expertise in criminal and regulatory matters and his skill in leading cross-border legal teams ensure that the organisations and individuals he represents benefit from bespoke, intelligent defence that challenges each and every aspect of the allegations made against his clients.
Josh is an English solicitor and US-qualified lawyer who defends companies and individuals in complex cross-border investigations, white collar crime prosecutions and civil regulatory actions. He also advises fintech, cryptocurrency and early-stage technology firms on compliance with anti-money laundering, sanctions and bribery regulations in the US and UK.
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His caseload includes many of the most complex, challenging cases involving national and international agencies. He has expertise in handling regulatory and compliance cases in a wide variety of countries and regularly handles the most notable financial services cases.
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Her intelligent management of investigations in various jurisdictions and her eye for detail in large, complex cases have led to her impressing senior figures in both the legal and business world. As a result, she has been heavily involved in some of the most significant tax fraud cases of recent years.
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WEBINAR: The Cum-Ex Files: Taking a close look at all aspects of Europe’s biggest-ever tax investigation
The response of enforcement agencies to Cum-Ex was analysed in depth during Rahman Ravelli’s online event examining the rapidly-developing, Europe-wide tax investigation.
30 September 2020