Criminal Tax Law: Investigations regarding Cum-Ex Transactions

Since October 2014, several public prosecutor’s offices have been investigating Cum-Ex transactions, which have already led to several seach warrants.

German Version: 

Steuerstrafrecht: Steuerstrafrechtliche Ermittlungen wegen Cum-Ex-Geschäften

Cum-Ex Criminal Proceedings

1. How do Cum-Ex deals work?

Cum-Ex transactions enabled investors to reclaim taxes they had not previously paid. The functionality of these transactions, also known as dividend stripping, is described in a simplified example. The figures are chosen completely arbitrarily; exchange rate fluctuations are not taken into account, as are exchange rate hedging transactions, which in practice cushion possible exchange rate risks.

Shareholder A holds shares in company U worth EUR 100,000.00. The first act of the Cum-Ex transaction takes place shortly before the day of dividend payment, also known as the “ex-day”. Ideally, the (gross) dividend is deducted from the stock market price on this day, after all, the shareholders have received the dividend and a buyer who acquires the share one day later does not receive the dividend. The day before the dividend payment is referred to as the “cum day”. The price difference in the idealized case between cum day and ex day is therefore exactly the dividend determined at the Annual General Meeting. We can hold on: Before the dividend payment, the share price with dividend (cum: lat. “with”), after the dividend payment, the dividend is deducted from the share price (lat. ex: from/from, out).

At the latest on the cum day, an investor B buys C shares in the company U from a foreign investor – worth 100,000.00 euros. The foreign investor C does not own any shares in the company U. It is a so-called short sale, i.e. in order to be able to fulfil its delivery obligation to B, investor C must procure the shares for itself. This is not unusual in itself, however, short selling is commonplace.

The ex-day follows: A receives the dividend on his shares in the company U – 4,000.00 euros are distributed to him. However, A will not actually receive the full dividend, but only an amount of 3,000.00 euros. The company retains 25% of the dividend for the state as capital gains tax. However, for the 1,000.00 euros withheld, A receives a certificate with which he may be able to have the capital gains tax refunded. The shares of company U, which A holds in its custody account, are only worth EUR 96,000.00 after the distribution of the dividend (ex-dividend price).

A now sells its shares to the foreign investor C at the current price of EUR 96,000.00. C can thus fulfil its obligation from the short sale to B. The “problem” for B is now that he has paid C 100,000.00 euros, but only receives shares worth 96,000.00 euros (share price without dividend). This results in a compensation payment from C to B of EUR 3,000.00 – the (net) dividend without tax. For the missing EUR 1,000.00, B can have his custodian bank issue a tax certificate with which he – just as A before – can possibly have the tax refunded. Economically, B is exactly the same as A. Unlike A for the dividend distribution, however, B has just not paid any capital gains tax, so that the claim for tax refund against the tax office has no real basis.

The last strike follows: B sells the shares back to the original owner A at the current price of 96,000.00 Euro. For A, everything is back to normal. In turn, it has values of 100,000.00 euros, namely the shares that are currently worth 96,000.00 euros, the dividend payment of 3,000.00 euros and the tax certificate with which it can have the remaining 1,000.00 euros of the dividend refunded by the tax office. However, such a tax certificate, with which the tax office has to reimburse 1,000.00 euros, also has B, although – unlike A – he has never paid taxes.

This “out of nowhere” claim of 1,000.00 euros is now usually divided between the three parties involved, namely investors A, B and C.

2. Money out of nowhere – How can this be?

This type of business was made possible by § 39 AO. This norm regulates to whom which assets are to be attributed for tax purposes. In the case of a securities transaction around the dividend payout date, this can be two persons. On the one hand, the holder of the security as legal owner – in our example: A – and on the other hand the purchaser as economic owner – in our example: B.

The business model is anything but new. The Federal Fiscal Court, Germany’s highest tax court, ruled back in 1999 that it is basically legal. This line of law was confirmed several times in the following years. As each case concerned individual questions, one can argue splendidly to what extent the judgments apply to Cum-Ex deals as a whole. Parts of the technical literature, but above all the tax authorities still considered the business to be illegal. It can therefore be said that the legal assessment was and is controversial.

The legislator saw the problem of the double assertion of capital gains tax on dividend payments and therefore created § 20 I No. 1 S. 4 EStG in 2007. The problem with this regulation, however, is that it is not applicable to foreign investors. The case described above is not covered by the standard at all – although it was already the main application case for cumex transactions at that time. The gap in the law accepted by the Federal Ministry of Finance was only closed in 2012.

3. Criminal liability of cum-ex transactions

In addition to the question of whether or not the tax advantage was obtained lawfully, it is particularly interesting to ask whether the parties involved in a cum-ex transaction have committed a criminal offence.

The punishability depends in principle on the tax illegality of the transaction, however, there is no automatism. Just because dividend stripping is classified as illegal under tax law does not mean that it is also punishable under criminal tax law. The fact that a business model that has been tolerated for years should suddenly be punishable – even retroactively – raises the question of criminal liability in legal policy matters.

4.  Abuse of legal construction?

In order to classify a tax conduct as tax evasion, the disputed transactions must violate applicable tax law. However, the Cum-Ex-Trade model actually only made use of tax law options and gaps, as explained above.

An abuse of legal structures according to § 42 AO is discussed as a starting point for behaviour contrary to tax law. The law defines abuse of legal structures as the choice of an inappropriate legal design that leads to a tax advantage for the taxpayer or a third party that is not provided for by law in comparison to an appropriate design. However, since the Federal Fiscal Court has recognized cum-ex transactions as a generally permissible tax design tool and has only assumed abusive behaviour in special circumstances, the assumption of design abuse is rather remote. Moreover, the legal principle lex specialis derogat legi generali precludes the applicability of § 42 AO. The Income Tax Act contained more specific provisions that take precedence over the more general provision of § 42 AO (cf. BFH, judgment of 15.12.1999, BStBl. II 2000, p. 527[532]). This legal view is also supported by numerous expert opinions that have declared the business model legal.

But of course there’s still a strange feeling. Obviously, the entire business model was designed from the outset to achieve a tax advantage that did not actually exist. Obviously, some effort was made by the participants to obtain the tax certificates for the capital gains tax twice.

5. Decision of the Federal Fiscal Court

The discussion about the criminal liability of cum ex transactions was rekindled by a decision of the Federal Fiscal Court of 16.04.2014 (Ref. I R 2/12). The Federal Fiscal Court has declared the previous practice illegal. He now negates the attribution of the assets to the purchaser under tax law – B from our example is no longer regarded as the economic owner within the meaning of § 39 (2) AO according to this case law. The Federal Fiscal Court justifies the denial of economic ownership on the purchaser side with the concrete contractual network of the individual case to be decided.

What is striking about the Supreme Court’s decision is the cautious choice of words. It cannot be inferred from it at the moment that the Federal Fiscal Court wants to completely turn away from its previous line of jurisdiction. Thus, the experts also disagree on the evaluation of the judgement. For the most part, however, the decision is not perceived as a fundamental judgement on cumex transactions. It can be assumed that further clarifying judgements will follow.

The solution of the BFH is dogmatically clean. A viable way has been found to make the old cases manageable under tax law – the gap will be closed from 2012 anyway – which will also have a positive effect on the tax authorities. However, if Cum-Ex trades are now classified as contrary to tax law, it is not a big step to look for a tax offence in them. As the searches show, the risk of criminal prosecution is very real.

6. Persons affected by prosecution measures

Criminal proceedings threaten against all parties involved in the transaction, but also by their advisors.

In the above example, A has not in itself obtained an unlawful tax advantage. He himself has finally obtained the tax certificate legally. However, the unjustified right to a tax refund only arose through his participation in B. Depending on the form of the individual case, it is therefore conceivable that A and C will be prosecuted either as accomplices in the tax evasion of B because the investigating authorities adopt a joint crime plan and a joint commission of the crime. If one considers the contribution of A and C to the crime to be lower, the possibility of aid to tax evasion by B remains.

This may affect smaller investors who have “lent” a block of shares to foreign investors before the dividend record date and have been rewarded with a fee – without knowing what the investors are actually doing with the package.

At the moment, however, the investigations are not only directed against the investors themselves, but also against their tax advisors. The spectrum of consultants ranges from tax consultants to large auditing firms. The specific circumstances of the individual case are also important for their risk of criminal liability. For example, if a tax consultant only includes in his tax return the capital gains tax certificates submitted by his client without knowing what the background to the certificates is, participation in the tax offence is ruled out because of his ignorance. It’s different when he set up the whole deal.

7. Intentional tax evasion?

However, the initiation of an investigation does not mean that those affected by it will actually be convicted. Because even if objectively the offence of tax evasion by Cum-Ex transactions is fulfilled, this does not automatically lead to a punishment. As with any other offence, tax evasion also includes the so-called subjective offence. This means that the perpetrator can only be punished if he can be proven to have acted intentionally. Intent means that the offender has deliberately committed the offence in full knowledge of all its objective characteristics.

In the transactions surrounding the dividend record date, there are clear doubts about the intention of the participants. Firstly, the business model was so widespread that even the Federal Fiscal Court in its decision of April 2014 spoke of “widely accepted practice”. The extent to which the parties involved actually assumed that they were settling a completely legal transaction under tax law is a question that must be carefully examined for each individual case. There is certainly defence potential here.

Especially for the smaller investor, there is the possibility of invoking an error according to § 17 StGB as a further “lifeline”. The provision applies if the perpetrator lacks the insight to do wrong during the commission of the offence. This is particularly important for investors who have received expert advice before the transactions were settled. After the “tax saving model” was widespread and discussed, an investor who refers to the advice of his (tax) advisor cannot be accused of criminal law.

8. Witness or accused?

A not to be underestimated danger exists for investors, who are to testify as witnesses against the large investment companies. Because precisely because it is not clear how much their contribution to the crime is to be assessed, there is the danger of “talking one’s head off” in such a procedure. Anyone who is to testify in such criminal proceedings and has previously participated in a cum-ex transaction as a holder of securities is therefore well advised to seek independent expert advice before testifying in order to avoid suddenly becoming a defendant in an investigation.

9. Upshot

Many voices have considered Cum-Ex transactions to be completely legal and the initiation of criminal investigations highly unlikely or even absurd. Critical speeches were not taken seriously – cries of protest! The initiation of criminal investigations, as has been pointed out, is by no means as absurd as it was previously claimed. Because one has to admit that the billion-dollar business is clearly at the expense of the tax authorities. All parties involved were aware that only a clumsy legal situation and regulatory gap had been exploited. But precisely because the legal structure is so controversial, there is a lot of room for argumentation and negotiation for prosecutions under fiscal criminal law.