Over seven months ago, Mark Steward, Executive Director of Enforcement and Market Oversight at the UK Financial Conduct Authority (FCA) announced that the FCA had been working closely with European authorities “for some time” on investigations into “substantial and suspected abusive share trading” in London’s financial markets. This trading activity allegedly supported dividend stripping tax avoidance schemes that caused losses of €55 billion in tax revenues across Europe.
As we await the outcome of the FCA’s investigations, which were said in February 2020 to be “very close to their conclusion,” there has been an acceleration in related enforcement and civil action across Europe including; arrests and convictions which we expect to continue for some time.
This article focuses on the risks and recommended actions for asset management firms which have either participated in, or otherwise been exposed to, dividend arbitrage schemes. While dividend arbitrage can represent a legitimate tax avoidance strategy, in the current regulatory and enforcement climate firms engaging in such practices would be well advised to check their historic transactions and exposure and confirm their policies and procedures are effective in detecting, and preventing, future abuses.
In determining their potential civil or enforcement exposure, the core question asset management firms should bear in mind is the underlying purpose of the relevant transaction.
In determining their potential civil or enforcement exposure, the core question asset management firms should bear in mind is the underlying purpose of the relevant transaction. Was the transaction a legitimate tax avoidance strategy, or was it contrived to artificially generate tax claims or exploit differentials in tax policies? Tax avoidance schemes falling in the latter category, which may comply with the letter but not the spirit of the law, could draw the scrutiny of the FCA or other relevant authorities.
In this context, this article addresses the following:
There are two types of dividend arbitrage scheme that are under focus by regulatory and enforcement authorities, known as “cum-ex” (“with-without”) or “cum-cum” (“with-with”). This terminology refers to the nature of dividend rights held by the relevant parties to the transactions – with or without dividend rights.
Media attention has primarily focused on cum-ex transactions, which have accounted for the substantial losses to European Governments already assessed. Cum-ex is a trading strategy under which traders obtain two tax refunds of dividend withholding tax (“WHT”):
– Where countries have double taxation treaties, overseas investors may be entitled to a refund of dividend WHT on shares held in domestic companies.
– Investors could transfer or borrow shares in the domestic companies immediately prior to the distribution of a dividend. This allowed multiple ownership of the shares around the dividend date, and confusion over who had accounted for the WHT.
– The parties involved in the scheme were each able to request WHT certificates, and therefore each make a corresponding claim for the same WHT.
In other words, in respect of one WHT payment, multiple refunds could be generated. The profit realised through this activity could then be shared between the relevant parties.
Cum-cum or “dividend washing” schemes are aimed at exploiting differences in tax rates between jurisdictions, and buying and selling shares around dividend payment dates:
Cum-cum is in some respects indistinguishable from dividend stripping activities, under which shares are purchased before a dividend is declared with the intention of selling them immediately after payment of the dividend. The expectation is that the shares will have risen in value because of the anticipated dividend payment, but fallen by the time the shares are sold. Like cum-cum, the strategy is based on the expectation that the price will not fall by as much as the dividend received.
In Europe, legal and regulatory action against suspected abuses in cum-ex practices commenced in 2012, when the German Government banned the means of claiming double ownership. Other European Governments followed suit, and have also sought to close loopholes. Cum-cum transactions have received less attention across Europe, but the German Government introduced a new law in 2016 requiring domestic investors to hold shares for at least 45 days surrounding the dividend date before the investor can qualify for a tax refund.
Germany and Denmark
The German and Danish Governments have been particularly active in investigating participants and launching proceedings. Recent high-profile actions include the following:
European Banking Authority and European Securities and Markets Authority
Further investigations, inquiries and proceedings across Europe are anticipated, in particular in view of a recent report issued by the European Banking Authority (“EBA”). In 2018, the EBA was mandated to carry out a review into dividend arbitrage schemes. In May 2020, the EBA published its findings and recommendations:
UK – the FCA
The FCA launched an initial review back in 2017, prior to the EBA and ESMA’s mandates. The FCA’s 2017 report highlighted deficiencies in the monitoring, detection and remediation of potentially abusive practices by financial institutions, noting that “some firms may not have identified the risk posed by contrived or fraudulent trading for the purposes of making illegitimate WHT reclaims.” The FCA emphasised the need for firms to monitor their existing business and assess new business opportunities, and to report their concerns to the FCA in accordance with their reporting requirements.
As much of the trading activity primarily took place in London, and many of the participants were UK nationals, UK-based conduct will be a focus of much of the European enforcement action. The FCA’s recent announcement that its own investigation findings are imminent relates to investigations into 14 financial institutions and 6 individuals.
By putting the regulatory issues of the dividend trading schemes in the spotlight, the EBA’s report provides a basis for future enforcement action. Accordingly, it will likely lead to further scrutiny around relevant trading activities and increase Europe-wide expectations on enhanced monitoring and controls to mitigate the risks of abusive actions.
On 24 September 2020, the European Securities and Markets Authority (“ESMA”) published a final report on its own two-year review into dividend arbitrage schemes. ESMA’s report supplements the EBA’s review, by focusing on the importance of increasing the cooperation between national authorities in sharing information, to assist in identifying and deterring relevant schemes.
As demonstrated by some of the recent proceedings, participants located outside the country of the relevant tax liability may still face scrutiny.
Asset management firms may utilise dividend arbitrage strategies to reduce their tax liabilities, or may otherwise be party to such schemes on behalf of their clients or connected parties. Firms may have participated in the schemes directly, or been involved, knowingly or unknowingly, in relevant activities such as share lending, to facilitate other participants in the schemes.
The strategies deployed by or connected to firms may represent entirely legitimate tax avoidance strategies. However, the increased scrutiny, regulation and enforcement activities across Europe heighten exposure. As demonstrated by some of the recent proceedings, participants located outside the country of the relevant tax liability may still face scrutiny.
Firms face two key risk areas:
In all the circumstances, the core question to ask and consider is whether there is a legitimate purpose to the transaction. In its 2017 review, the FCA highlighted the following activities as relevant conduct for the assessment of the legitimacy of dividend arbitrage schemes:
Any transaction deemed improper could, under UK law, give rise to civil liability, or constitute a regulatory breach or criminal offence. These include:
To mitigate their exposure to regulatory or enforcement sanction, firms should consider the following:
Dividend arbitrage is a highly complex area, and there have been conflicting decisions on the legitimacy of relevant practices. However, the widespread publicity, recent regulatory and enforcement efforts, and the gathering context of financial recession, means this is likely to remain a key area of focus for some time to come. Asset management firms, alongside other financial market participants, are likely to face particular scrutiny, and they would be well advised to proactively review, identify and assess their historic and ongoing risks and exposure.