What UK Financial Institutions Need To Know About Cum-Ex Trading

Denmark's English Court journey to recover the proceeds of tax evasion from a trader appears to have come to an end. What now for enforcement against cum-ex traders?

The issue of cum-ex trading has returned to the spotlight after Denmark's £1.5 billion claim against British hedge funder Sanjay Shah, expected to become one of Britain's longest and most expensive trials, was yesterday dismissed by the English High Court. The claim alleged that Shah, through his fund Solo Capital Partners, masterminded a cum-ex trading scheme that defrauded the Danish tax authority, SKAT, of vast sums of money between 2012 and 2015, naming 114 defendants. The English High Court's dismissal of the case, on a point of policy rather than merit, was a narrow escape for Shah, who has emerged as a central figure in the trades and remains subject to investigation and prosecution in other jurisdictions. Shah maintains that his actions were lawful. 

In a four-day High Court trial covering preliminary matters, Shah's lawyers argued that the Court did not have the jurisdiction to hear the case, as it is "governmental in nature" and attempts to utilise the English court to enforce foreign revenue laws are forbidden under what is known as the 'Revenue Rule'. In his judgment released yesterday, Judge Baker agreed; holding that the claim was an attempt by the Danish authority to recover lost tax revenue, which is inadmissible in an English court. SKAT has stated its intention to appeal; arguing that it is pursuing a civil claim rather than attempting to enforce its revenue laws. The tax authority has also filed civil suits against over 500 individuals or entities in six other countries; the US, Dubai, Germany, Malaysia, Canada and Denmark.  

Previously an employee of Credit Suisse and Rabobank, Shah claims he first became aware of traders profiting from dividend taxes in his early career and has since merely benefitted from a "legal loophole". Danish authorities disagree and have launched criminal prosecution against Shah for defrauding the treasury, which could result in a 12-year prison sentence in the event of a guilty verdict. Shah has also been charged with 55 counts of money laundering in Hamburg, covering trades between December 2011 and September 2015. German prosecutors argue that Shah laundered the profits from tax fraud by making untrue statements about dividend arbitrage trades when filing tax-refund claims. The investigations demonstrate how seriously cum-ex trading is being taken and the potential consequences for those involved.

What is cum-ex trading?

Cum-ex trading is a method used to engineer multiple refunds for withholding tax ("WHT") paid on a dividend. Typically, company shares are sold or swapped prior to a dividend payment in order to produce two tax refunds in respect of just one underlying withholding tax payment. 

The possibility and legality of such cum-ex trading is dependent on national tax law and/or any double taxation treaties between the relevant country and another. As such, it could potentially impact a number of European countries who impose withholding tax on dividends; it is estimated that the total costs to affected European national tax authorities are in excess of €55 billion between 2001 and 2012. Germany and Denmark are most heavily impacted, losing €5.7 billion ($6.4 billion) and 12.7 billion kroner ($2 billion) respectively. Investigations are also being carried out in Belgium and Austria, whilst the UK is assisting foreign authorities, including those of France, Germany, Italy and Denmark. 

What are the views of Regulators and Enforcement Authorities? 

German authorities consider that cum-ex trades made prior to a 2012 change to the tax code likely constitute tax evasion, and are considering around 1000 suspects in ongoing investigations, whilst the European Banking Authority stated that "multiple claims of the same withholding tax could amount to a tax crime", and that the “handling of the proceeds from tax crimes is likely to amount to money laundering, irrespective of where the tax crime took place". The UK Financial Conduct Authority ("FCA") has declared that trades made without sufficiently detailed assessment could be market abuse as they may give "false or misleading signals about the supply of, or demand for the relevant security".

The FCA has launched investigations into eight individuals and 14 firms associated with cum-ex trades and has declared that it considers such trading abusive. One of its largest investigations was, however, recently halted after a High Court judge ruled that the FCA must wait until the conclusion of SKAT's case against Shah. The case's dismissal yesterday raises the possibility that the FCA may now restart its investigations.

How could UK financial institutions be affected by cum-ex trades?

The UK does not itself generally impose WHT on dividends but, due to its position as a major European trading hub, UK financial institutions could be implicated. Many of the trades were allegedly executed through the UK, or linked to UK parties via divisions on continental Europe. Therefore, UK institutions and individuals may be subject to German or Danish law in this area, as well as that of other affected jurisdictions, which could result in prosecution, civil suits or regulatory action from European authorities. For example, three of the five individuals charged by Frankfurt prosecutors in May 2018 were formerly based at HypoVereinsbank's London division.

The trades, and their possible illegality, impact a range of parties from traders to lawyers, banks or accountants. German authorities are investigating approximately 100 banks, including Deutsche Bank, DZ Bank, Commerzbank, HypoVereinsbank (the German division of Italian bank UniCredit), Maple Bank GmbH (the German branch of Canadian bank Maple Bank), Santander, Macquarie, and state-owned banks WestLB and HSH-Nordbank, whilst the Danish authorities have subpoenaed more than 420 companies and individuals suspected of involvement. Civil suits have also been brought against advisors such as EY, and against a partner at Freshfields Bruckhaus Deringer, in relation to advice given to Maple Bank GmBH, demonstrating the depth of possible implications from cum-ex trading and associated activities.

It is clear that a wide spectrum of UK financial institutions could be implicated and it seems likely that investigations could be ongoing for years to come. 

What about other forms of dividend arbitrage transactions?

The term "dividend arbitrage" is sometimes used to describe the sort of cum-ex trades involved here.  However, as noted in the ESMA report here, the term can also refer to a range of transactions where the aim is not a double refund of the withholding tax but simply to benefit from a lower (or even nil) rate of withholding tax on the dividend.  A paradigm example of that would involve a shareholder lending or repo'ing shares over a dividend record date to a transferee who seeks to benefit from a better withholding tax exemption than the original shareholder.  The tax authorities in issuer jurisdictions have adopted a number of approaches to such trades, both on a historic and go-forward position.

As a result of the likely renewed regulatory focus on transactions of this type, UK financial institutions may want to review their internal controls and policies, particularly for short term trades over dividend record dates.

Authors: Ruby Hamid and Victoria Padley.