Tax Dodge That Cost the German Treasury Billions

The maneuver was brilliant, a virtually risk-free transaction that guaranteed hefty returns after only a few days. Then the taxman caught on.

For the better part of a decade, German authorities say, dozens of banks and brokerages helped investors snatch billions of euros from the national treasury by exploiting an interpretation of the tax code that appeared to let multiple people claim ownership of the same shares of stock and—crucially—the right to a refund of taxes withheld from dividends, Bloomberg reported.

“They seemed to be creating money from nothing,” says Tobias Rudolph, a criminal defense lawyer in Nuremberg. “Common sense should have told anyone that this couldn’t be right.”

The deals involved a type of short sale made just before a company was due to pay a dividend. (In conventional short sales, investors sell stock they don’t own, hoping to profit by repurchasing it later at a lower price.)

When German companies pay dividends, they withhold about a quarter of the money to cover any taxes the shareholder might later owe. Shareholders get certificates showing how much was deducted, and the amount can be credited against their tax bill or, if they owe no additional taxes, refunded.

In the case of the short sales in question, two parties claimed to own the same stock and got certificates. Prosecutors say that in some instances, three or more investors may have received certificates for the same withholding tax.

Cum/Ex Trades

Financial houses, accounting companies, and law firms across Europe and the US participated on some level: doing the deals, arranging them for clients by acting as custodians, issuing tax certificates, or financing transactions.

The practice—which has come to be known as “cum/ex”, a Latin phrase that means “with/without,” a reference to the vanishing dividend payments in the trades—is widely reported to have cost German taxpayers more than €10 billion ($11.7 billion).

Suspects Cooperating

Frankfurt prosecutors in May said they had charged six people, including former investment bankers at UniCredit SpA’s HVB unit in London.

Investigators in Cologne are preparing their first indictments in a parallel probe, according to people familiar with the matter. That inquiry has been under way for about a half-decade but is picking up speed as suspects begin to cooperate.

The cases involve hundreds of individuals at banks including Barclays, Macquarie, Bank of America, and BNP Paribas, say the people, who declined to be identified because they’re not authorized to discuss the matter.

A third team, in Munich, is looking into an investment fund that specialized in such transactions. “A shockingly large number of players sought to unscrupulously enrich themselves at the public’s expense,” German opposition lawmaker Gerhard Schick said in a report to parliament. “It was a glittering party.”

Commerzbank, Deutsche Bank, HVB, German private lender M.M. Warburg, and Clearstream, the unit of Deutsche B?rse that settles trades, have acknowledged that transactions they were involved in are being investigated.

Deutsche Bank AG says it didn’t participate in cum/ex trades as a short seller or buyer, but it worked on deals for some clients. M.M. Warburg & Co. says any trades it made were in line with the law. Clearstream Banking AG says it’s cooperating with the prosecutors. The other banks declined to comment.

Murky Transactions

The practice came to light about a decade ago when officials at various tax offices started questioning requests for refunds on murky transactions totaling hundreds of millions of euros. As they dug more deeply, they stopped honoring the certificates and alerted prosecutors. A 2012 reform of the tax code brought the practice to a halt, but authorities had accepted the certificates for years, and lawmakers did little to tighten the rules despite repeated warnings, so the debate today centers on whether the trades were legal before 2012.

Banks, funds, and investors that participated in the trades relied on legal opinions from lawyers that said the transactions were allowed. But prosecutors say those documents oversimplified the matter and that it was clear the transactions involved double-dipping on the refunds.

The probes have led to raids in more than a dozen countries over the past four years, and investigators have reviewed thousands of emails, voicemails, and Bloomberg chat sessions that traders used.

They got a breakthrough last year when a handful of participants agreed to provide details of the deals. This summer the Bonn Regional Court is set to rule on whether the prosecutors can offer leniency to key witnesses.