Sunday, August 8, 2021

Germany Throws the Book at Tax Criminals

Cross-border Securities Loans Targeted by EU Tax Auditors

Author: David Schwartz J.D. CPA

German courts and regulators have put securities lenders on notice that cross-border withholding tax (WHT) reclaim "schemes" are now "crimes." Recent developments in Germany have cleared the way for sweeping tax audits and potential criminal prosecutions of borrowers and lenders reaching back 25 years. The so-called "cum-ex" trades have been a focus of European regulators, particularly in Germany and Denmark, whose treasuries have been hit hardest by these trades. Lenders are being advised that there is new potential for legal and criminal jeopardy attached to cum-ex securities lending transactions and that principals and their service providers should be ready for heightened scrutiny.[1]


Up until now, WHT reclaim schemes occupied a liminal space in German law, where they were technically not illegal but considered abusive.[2] A recent decision by the German federal court has now brought some clarity on the legal status of these schemes. On July 28, 2021, the Federal Supreme Court rejected an appeal of a fine for tax fraud imposed in March 2020 on two former London share traders and the Warburg Bank. In the first ruling at the federal level, the court ordered one of the traders to pay restitution of 14 million euros and imposed a fine of around 176 million euros on Warburg Bank. The court also imposed suspended jail terms. This court ruling is significant because it moves tax fraud arising out of cum-ex and cum-cum transactions from merely abusive activity and squarely into the realm of criminal conduct. 


With the Federal Supreme Court's ruling in mind, the German Bundestag is also considering amendments to criminal laws that would extend the statute of limitations for serious tax violations to 25 years, giving tax regulators more time to detect and prosecute WHT reclaim schemes. 


Efforts to catch tax violators involved in WHT schemes are already underway throughout the EU. In July, tax regulators in Switzerland arrested a German lawyer accused of being involved in 'cum-ex’ tax infringements. Swiss officials have indicated that the lawyer will likely be extradited to Germany for prosecution. 


In a July 9th, 2021 interpretive letter, the German Finance Ministry (the BMF) updated and tightened its guidance on the tax treatment of cum-ex and cum-cum transactions. Ultimately, the BMF's interpretation removes any ambiguity that attempts to avoid a definitive WHT on dividends or derive tax benefits from WHT reclaims not intended by law are abusive.[3] Further, BMF's letter puts the onus of notification and correction for past WHT reclaims on the taxpayer.[4] If they fail to notify taxing authorities and make amends, they risk criminal prosecution.  


Under this new guidance, every securities lending transaction over a dividend record date with WHT tax implications will be open to examination on a case-by-case basis to determine whether the beneficial ownership in the underlying shares has been transferred for tax purposes and whether the borrower or lender is entitled to any reclaim. While many market participants may have long since given up dividend arbitrage activity, given the scope of the potential tax audits, they may be forced to justify decades of trades involving dividends for German and Danish issuers. 


Crossing the line on cum-ex trading can spell the end of respected institutions, as Maple Bank GmbH learned in 2016 when German financial regulators forced the bank into liquidation over repayment of hundreds of millions in taxes related to cum-ex transactions. Borrowers, lenders, and their intermediaries, bankers, and service providers should be on notice that there is new legal and criminal jeopardy attached to cum-ex and cum-cum securities lending transactions and that they should take steps to keep these within the law. The regulators are watching. 


[1] Banks all over Europe have been snared in German and Danish investigations of WHT reclaim schemes. 


[2] The fundamentals of a cum-ex trade employ a complex process of borrowing and shorting securities over a dividend period in such a way that allows two parties to claim withholding tax exemptions on a single asset.


[3] In addition, the BMF letter contains a non-exhaustive list of scenarios for cum / cum arrangements that have not been dealt with explicitly at this point. 


[4] When dealing with cum-cum issues, the taxpayer must report and correct if the taxpayer subsequently realizes before the end of the assessment period that they have made objectively incorrect or incomplete submissions in their tax return, and this results in a reduction of taxes due or refundable (see German Fiscal Code (AEAO) § 153, numbers 1 through 3).