by Cezary Podkul, ProPublica, and Allan Sloan, The Washington Post, May 3, 2016, 7:59 a.m.
After publication of our joint investigation, Germany’s Commerzbank said it would stop participating in the transactions detailed in this storywithout waiting for the government to ban them. In addition, a spokesman for the German finance ministry called the transactions “illegitimate because their sole purpose is to avoid the legal taxation of dividends.”
German companies are known for paying some of the heftiest dividends among world stocks, one reason U.S. investment giants such as BlackRock and Vanguard are among the biggest holders of German shares.
But Wall Street has figured out a way to squeeze some extra income from these stocks. And German taxpayers pay for it.
[drizzle]A cache of confidential documents obtained by ProPublica and analyzed in collaboration with The Washington Post, German broadcaster ARD and the Handelsblatt newspaper in Düsseldorf details how Wall Street puts together complex stock-lending deals that drain an estimated $1 billion a year from the German treasury.
Similar deals extend beyond Germany, siphoning revenue from at least 20 other countries across four continents, according to the documents, which show how “dividend-arbitrage” transactions — known in the trade as “div-arb” — are structured and marketed as tax-avoidance vehicles.
The trove of transaction logs, emails, marketing materials, chat messages and other communications among deal participants involves a who’s who of the world’s big banks and institutional investors.
In deals like these, some of America’s largest money managers briefly lend out some of their German holdings each year. Those shares are temporarily held by German investment funds and banks that by law pay no tax on German dividends or can claim refunds for tax withheld. The borrowed shares are returned shortly after the dividend is paid.
The banks or funds that borrowed the shares receive the dividends tax-free and then transfer that money to the stocks’ original owner, minus fees for middlemen. The foreign investors typically end up with added income equivalent to about half the dividend tax that would have been owed.
Some firms, like BlackRock, run their own security lending programs, while others lend through big global banks that package the deals.
Vanguard, BlackRock and Fidelity said their securities lending follows applicable laws and is designed to help investors. Mike McNamee, a spokesman for the Investment Company Institute, which represents large money managers, said “funds have an obligation to maximize returns for shareholders.”
How ‘Div-Arb’ Slashes Taxes at Germany’s Expense
Div-arb has been an open secret on Wall Street for years. It faces new scrutiny in Germany amid questions about its legality and a government push to end it.
The practice — sometimes called “dividend washing,” “dividend stripping” or “yield enhancement” — is the latest version of a long-running game in which creative bankers exploit gaps and inconsistencies in foreign tax systems to benefit wealthy clients. As with corporate inversions and schemes to hide money in offshore accounts, governments lose billions and the tax burden shifts to others.
Some say governments have no one but themselves to blame. “Unless governments are going to get serious about harmonizing and standardizing tax rates, then governments leave themselves open to this loophole,” said Josh Galper, managing principal of Finadium, a financial consulting firm in Concord, Mass.
Legal experts who reviewed trades detailed in the documents said they might cross the line because German law forbids transactions whose sole purpose is to avoid taxes — a standard that is extremely difficult to meet. Germany’s highest tax court recently invalidated one div-arb transaction that it called an “empty shell.”
In the United States, Congress put an end to div-arb in 2010 after a scathing report by the Senate Permanent Subcommittee on Investigations two years earlier.
Shown some of the German transactions in the cache, Reuven Avi-Yonah, a University of Michigan Law School professor who helped Senate investigators in 2008, said he believes they were “pretty clearly tax-motivated.”
“Regardless of whether you have an obligation to your shareholders, that does not extend to things that you know have no motivation other than reducing taxes,” Avi-Yonah said. “That’s illegal under current German law.”
In one email exchange, a manager of Norway’s sovereign wealth fund wrote to intermediaries to confirm his understanding of a lending transaction. The purpose of the loan, he wrote, was to “avoid” a 15 percent withholding tax on shares of international companies by agreeing to a 50–50 split of the taxes saved.
“We do not necessarily know the motivation for borrowing, or who the end user is, but are aware that tax considerations are one of several drivers for pricing these transactions,” a spokesman for the fund said in an email.
Sovereign wealth funds in Saudi Arabia, Kuwait and Singapore also lend shares for div-arb deals, the documents show. So do other investment managers in the United States, including Franklin Templeton and T. Rowe Price, both of which declined to comment.
Banks playing a role in such trades include Barclays, Goldman Sachs, UBS, Morgan Stanley, Citigroup, Merrill Lynch, JPMorgan, Deutsche Bank and Swedish bank SEB, among others, the documents show.
All the banks declined to comment except for Deutsche Bank and SEB, which said their transactions abide by all applicable laws and regulations.
In Germany, the most prominent participant is Commerzbank, which was bailed out by German taxpayers during the financial crisis and is still 15 percent owned by the government. Commerzbank declined multiple requests for comment.
For German lawmaker Gerhard Schick, deputy chairman of the Parliament’s finance committee, the irony stings. “Personally as a taxpayer, I feel as if somebody was pulling my leg when I found out banks that we rescued do trades at our expense,” he said.
“This is a no-go.”
Carefully Timed Trades
Div-arb is a big deal in Germany. A ProPublica analysis of five years of stock lending data for companies on the DAX 30 — the German equivalent of the 30-stock Dow Jones industrial average — shows that the number of borrowed shares typically climbed 800 percent in the 20 days preceding the dividend record date. That’s when companies identify shareholders who will get paid dividends.
Tax Avoidance Has a Heartbeat
Every year at dividend time, demand to borrow German stocks spikes. See the full interactive.
Twenty days after the record date, borrowings returned to prior levels, according to share lending volume from S&P Global Market Intelligence, which provided the data for ProPublica’s analysis.
The annual spikes in borrowing are as regular as blips on a heart monitor. By contrast, the number of borrowed shares of the Dow Industrials barely budges around dividend record dates.
There are no official statistics about the tax impact of div-arb. To estimate the annual loss to the German treasury, ProPublica calculated dividends paid by each DAX 30 company on the increased volume.
That amount comes to about $6 billion a year. Other German stocks pay an additional $600 million or so. Based on a typical tax rate of 15 percent for foreign owners, the combined loss is $1 billion