• Around 100 different international financial institutions have been implicated in Germany’s investigation into tax fraud
• Changing documentation requirements can be an effective way of cutting down on cum-cum and cum-ex schemes, research finds
• Some forms of tax exemption alleviate pressure on small and mid-sized enterprises that would otherwise face “double taxation”

“Once you identify a period of life in which people get to stay out late but don’t have to pay taxes – naturally, no one wants to live any other way,” notes American author and columnist Judith Martin, better known by her pen name, Miss Manners.

Sermonising on what she calls “the invention of the teenager,” Martin’s words have gained scope following the reveal of widespread abuse of tax systems in Europe and the US.

A police raid on the Munich office of BlackRock, the world’s largest asset manager, in the winter of 2018 underlined the seriousness of Germany’s long-running criminal investigation into tax fraud.

The fraud in question revolved around so-called cum-cum and cum-ex schemes which exploited loopholes in the German tax system, “infuriating” former finance minister and current Chancellor of Germany Olaf Scholz according to his Twitter account.

Much of this activity took place within the first decade of the 21^st century before changes to the law made such transactions harder to get away with.

Nevertheless, the scale of the problem was colossal. Around 100 different international financial institutions were implicated in the investigation, bearing ramifications for many other countries besides Germany.

A few weeks after the raid, the then editor-in-chief of Correctiv, a German non-profit investigative journalism group which delved deeply into the tax scandals, Oliver Schröm alleged that cum-ex transactions were still taking place in France, Italy, Spain, Norway, Finland, Poland and the Czech Republic.

An estimate from Christoph Spengel, Professor of International Taxation at the University of Mannheim Business School, places the revenue losses from both types of schemes at around $165 billion across the US and 11 European countries over the last 20 years.

Introducing his findings at a public hearing of the Subcommittee on Tax Matters of the European Parliament, Prof. Spengel called the sum of these crimes “the biggest tax robbery in European history.”

What are cum-cum and cum-ex transactions?

Elisa Casi, Evelina Gavrilova and Floris Zoutman at NHH Norwegian School of Economics write in Bloomberg that it is “notoriously difficult to enforce taxation on dividends” and that “abuse of dividend withholding tax (DWT) reimbursement systems through arbitrage is common in the US and Western Europe.”

Many countries impose a withholding tax on dividends paid to non-residents, as it would be difficult to collect the tax from the foreign payee after they have received the dividend. But, as long as certain conditions are met, non-residents such as companies or pension funds can apply for a refund of the withheld tax.

Cum-ex transactions exploit legal loopholes that enable multiple parties to claim a tax refund even though the tax was only paid once. As Prof. Spengel explains, it is essentially the tax fraud version of “double-dipping.”

Carrying out these trades typically follow a set course of action. The true owner of a stock or asset lends it to a bank. The bank then sells the shares to a third party with – or “cum” – a dividend, on or just before the dividend record date. The shares are delivered shortly after the date without – or “ex” – the dividend.

During the time most of the alleged fraud took place in Germany, the German tax code allowed a refund to be claimed by the original owner of the asset, who received the dividend and paid tax on it, and the third-party buyer. This buyer would therefore be reimbursed for tax they had not paid.

“The biggest tax robbery in European history”

– Prof. Christoph Spengel, University of Mannheim Business School

Cum-cum schemes are a little more complicated. They aim to exploit the differences in tax rates between jurisdictions while buying and selling stocks around dividend payment dates.

A foreign investor usually agrees to lend their shares to a domestic bank shortly before the dividend record date, allowing them to benefit from tax relief that would typically be reserved for domestic investors.

Prof. Spengel illustrates this in the context of the investigation in Germany.

“German shares are transferred into Germany shortly before the dividend record date to German banks based on a security lending contract. At the dividend record date, German banks are entitled to a refund of the DWT. Afterwards, all transactions are reversed. Instead of a dividend subject to limited liability to tax in Germany, non-resident shareholders receive a security lending fee which is tax-exempt for them”, he explains.

Is stricter enforcement of tax laws effective?

Casi, Assistant Professor at NHH, and her colleagues Gavrilova, Full Professor, and Zoutman, Associate Professor, conducted an analysis of reforms introduced in Denmark in 2016 to reveal whether they were effective at cracking down on DWT arbitrage.

Arbitrage refers to the simultaneous buying and selling of the same or similar assets in different markets to take advantage of differing prices. On its own, this is not necessarily illegal in many countries, though it is considered risky. However, it can become illegal when used to trick tax reimbursement systems, for example.

In 2015, Danish tax authorities discovered large-scale dividend arbitrage transactions that exploited the DWT reimbursement system, which the NHH researchers believe cost the country around $1.3 billion per year in revenue losses.

In response, the government changed documentation requirements to ensure that all organisations applying for reimbursements were eligible for them.

The NHH study finds this was highly effective at cracking down on arbitrage through cum-cum and cum-ex schemes, resulting in a large increase in DWT revenue and only a short-term negative impact on firms in Denmark.

The authors were able to evaluate the prevalence of cum-cum and cum-ex trades by reviewing raw data on stock lending. Because both types of transactions rely on assets passing through several pairs of hands, the number of stocks on loan rises sharply just before pay-out dates.

Professors Casi, Gavrilova and Zoutman reveal that these spikes disappeared after the reforms were introduced. Cutting down on this abuse of the tax system resulted in a 130 percent increase in annual DWT revenue, they add.

While this is a positive outcome for tax authorities, policymakers have to weigh the benefits of increasing DWT revenue against the potential costs of increasing the burden of documentation. There is a risk that foreign investors may be less interested in investing in local companies.

Fortunately, the Denmark example puts some of these fears to bed. The researchers find there was a reduction in investment after the reform, but only in the short term. The new documentation requirements also didn’t trigger any significant changes to companies’ dividend policies.

The authors explain stricter enforcement also led to similar results in Germany and Austria, both of which introduced similar measures in 2016 and 2018 respectively.

What are the benefits of making tax digital?

A study by the University of Cologne reveals that limiting the deductibility of expenses using pre-filled forms can help combat tax evasion schemes.

The research was conducted by Professors Michael Overesch, Martin Fochmann, Tobias Kölle and Frank Hechtner. They analysed three anti-tax evasion methods: the tax laws that regulate which expenses are deductible, the method of limiting deductible amounts to certain maximum amounts and pre-filling deductions on tax returns.

Their findings reveal that limiting tax evasion by disallowing the deduction of certain expenses is ineffective. They observe a shift effect in tax evasion but not a substantial decline. Similarly, they notice tax evasion through the overstatement of deductions is barely reduced.

“Automatic data exchange between tax authorities and employers, social security institutions and banks can enable pre-filling of tax returns,”

– Michael Oversesch, University of Cologne

However, their findings show that limiting the deductibility of expenses using pre-filled deduction avoids this tax evasion shift, making it a much more effective method to cut down on evasion schemes.

The trend in the UK and many European governments towards “making tax digital” could smooth the introduction of these reforms by making it harder for people to manipulate bank forms.

“Tax returns with pre-filled deductions represent a relatively new method. For example, electronic tax return programs fill in the current tax return with the previous year’s figures for initial guidance. Furthermore, automatic data exchange between tax authorities and employers, social security institutions and banks can enable pre-filling of tax returns,” says Michael Overesch, Professor of Business Taxation at Cologne.

The authors explain this could make it easier for people to complete the forms because most of the filling-in will be done by tax return software. They believe it would also make the tax system work better for “honest taxpayers.”

“The current method of limiting the deductibility of expenses requires democratic justification in each individual case, whereas pre-filling only requires a change in the administrative process and is essentially already performed by tax return software. More importantly, however, the disallowance or limitation of deductibility is a lump sum solution that also affects tax bills of honest taxpayers. Whereas pre-filling does not have any of these negative consequences on honest taxpayers,” Prof. Overesch explains.

Is tax exemption sometimes beneficial for the economy?

A certain level of tax exemption can be beneficial for society and is enshrined in tax law in many countries.

Until 2005, Finland operated under a system of full dividend imputation or avoir fiscal, meaning owners of private companies did not pay taxes other than company income tax on their dividends.

After reforms were introduced in 2005 and 2006, the Finnish tax authorities have allowed a full tax exemption on dividends distributed to shareholders of private companies as long as the dividends fall below a certain maximum amount as defined by law.

The purpose of this tax exemption was to alleviate the harmful effects of double taxation on company income, where tax is owed on dividends at both the corporate and personal levels. If not for this exemption, the effects of abandoning the avoir fiscal system would have been an additional burden on private small and mid-sized enterprises (SMEs), their owners and the national economy as a whole.

Eero Kasanen, Emeritus Professor of Finance at Aalto University School of Business, and Juha Kinnunen, Emeritus Professor of Accounting at Aalto, along with colleagues from UEF Business School, analysed financial and economic data on around 180,000 private Finnish companies for the fiscal years 2006-2010.

Their aim was to shed light on how tax considerations affect dividend decisions and earnings management in private SMEs, which typically face much less political pressure and fewer capital market incentives to reveal information through financial disclosures and stable dividend policies than their public counterparts.

The authors confirm findings from prior research that suggest dividends distributed by these companies are strongly influenced by the maximum amount of tax-exempt dividends allowed by the law.

“We document that the earnings management exercised by these companies is driven by two concurrent but opposite forces: the need for positive accruals enabling their current dividend distribution and the need for negative accruals to avoid a company income tax,” they write.

“When companies need positive accruals because they want to distribute more dividends than their cash flows from operations, we find that these companies tend to manage earnings upward to meet the dividends to be paid.

“Conversely, when companies pay less of a dividend as compared to their cash flows from operations (thus facing a need for negative accruals to avoid company income tax), we show that these companies manage their earnings downward.”

These opposite forces pushing companies’ earnings in different directions create a situation not unlike the Icarus story. Private SMEs don’t want to soar high enough for their wings to melt but neither do they want to dive low enough to end up floundering in the sea.

Of course, this is a process of continual readjustment. As with navigating the skies, where there are air currents and weather systems to contend with, so too is the financial world subject to change.

While the kestrel’s ability to hover in perfect stillness at exactly the right height is enviable, perhaps the reality for many companies is closer to the bobbing, dipping flight of a wagtail. Depending on circumstances, a firm might choose to manage its earnings up or down.

What is the role of business schools?

From these studies and the voices of expert faculty at business schools, it’s possible to gain a nuanced understanding of tax evasion and fraudulent transactions. These insights can provide guidance to policymakers drafting reforms to close specific loopholes or even aid in the building of investigations into criminal practices.

“Once you identify a period of life in which people get to stay out late but don’t have to pay taxes – naturally, no one wants to live any other way,”

– Miss Manners

More broadly, it is important for all members of society to develop at least a base-level understanding of tax systems and law, as every adult is culpable for paying their taxes incorrectly, irrespective of whether or not they did so on the back of bad advice.

The thought leadership that business schools are able to provide through teaching and research is invaluable. Tax is a complex topic and benefits from the large time investment researchers put into producing their peer-reviewed studies, as well as their surgical approach to using key terms.

After all, in this world, nothing can be said to be certain, except death and taxes.

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