Europe’s largest economy is facing its biggest post-war tax scandal. Germany’s tax system has been fleeced of $36bn since 2001, as a group of bankers, lawyers and stockbrokers have employed ‘unethical, at worst illegal’ techniques to avoid paying tax on large-scale stock transactions. This amount equates to approximately 10% of the annual government budget expenditure, surpassing the combined money spent per year on healthcare and education & research. In fact, German newspaper Die Zeit reported that the amount would be sufficient to cover the entire refugee influx for one year.
Following the Panama Papers scandal in 2016, the five largest economies in the European Union united to clampdown on tax activity that aimed to defraud national governments. Then Chancellor of the Exchequer for the UK government, George Osbourne, called the move a ‘hammer blow against those who hide their illegal tax evasion in the dark corners of the financial system’, as France, Germany, Italy, the UK and Spain began to share previously secret information to identify the beneficial owners of companies and trusts. However, the criminal activity embedded in the German state was not discovered as a result of these changes. The credit goes to a junior administrative assistant in the German revenue office, who analysed a substantial rebate received by a US pension fund. Further investigations then unearthed many more cases, eventually creating a spider web which has ensnared over forty German banks, some of whom had received state support in the height of the financial crisis, as well as many more international institutions. Initial warnings of this suspicious activity were aired in 1992 and were subsequently supported by five whistle-blowers. Nevertheless, these calls for an investigation remained ignored for the following two decades. The delay in tackling these problems came at a hefty cost: a further €7.2 billion robbed from the German state between 2005 and 2012 alone.
How Were These Individuals Able to Defraud the System?
Institutions employed ‘Cum Ex’ trades, which are effectively a sale of borrowed shares prior to a dividend’s payout date. Both the receiver of the shares and the bank, which would loan out the shares, would temporarily benefit from the receipt of a dividend tax rebate, for it appeared that both parties owned the same set of shares. This technique resulted in multiple capital gains tax refunds to be claimed from one payment to tax authorities.
Wide-spread malpractice capitalised on this loophole, which was subsequently closed down in 2012, however instead of ending this type of exploitation altogether, the finance ministry decided to accept changes proposed by a lobbyist group for the banks, which were passed into law in 2007. The amendment allowed for such trades to continue for the following five years, so long as a company’s clients were not domiciled in Germany. An internal report published by a civil servant in North Rhine-Westphalia, in October 2005, warned against these proposals, but warnings once again fell on deaf ears. There is evidence that these trades continued until 2016 in Germany, and are still widespread on the international stage too. Large banks in London generate over $1 billion per year using similar ‘dividend arbitrage’ strategies, which have helped clients reduce tax payments from 30% to a ceiling value of 10%. The Federal Reserve Bank of Richmond also opened a probe into practices by Bank of America Merrill Lynch, a firm that recorded $1.2 billion of revenue between 2006 – 2012 using trades that withheld taxes on stock dividends, as well as $100 million alone in 2013. The bank has profited on the spread for issuing a stock derivative, for which the institution takes ownership of the client’s stock, before then transferring it into a subsidiary domiciled in a country where tax on dividends is far less.
How Can the Authorities Clamp Down?
Derivative transactions are incredibly complicated. An increasing amount of post-crisis regulation has forced sell-side institutions to invent new tools to generate profitability for their clients. A simplification of such regulation, while encouraging greater trans-national data sharing, would encourage more firms to disclose the location of these housing subsidies, which in turn should prevent companies from exploiting so-called ‘havens’. An outdated tax system remains a primary concern too, as studies have shown that the utilisation of derivatives to circumvent tax regulation is in part due to the inconsistency and lack of clarity from the current reporting system. A US Congress Joint Committee on Taxation in 2008 found that the outdated tax system doesn’t just struggle to capture the more advanced arbitrage techniques, but it also fails to understand an effective tax rate for various derivative instruments. This is because sub-components of the derivative can fall into various tax categories. In addition, while many specialists are on hand to offer support with derivative-related tax avoidance, the services are often so costly that it offsets the possible gain of receiving the tax savings.
Currently, the authorities are focussed less on structural reform and more on extracting their pound of flesh from frequent legal battles, which to date have brought in record fines from the largest participants on the market. Banks also face the risk of having prior annual audits declared invalid, as well as losing previous and future tax reimbursements. Senior staff members are also in the firing line; if sentenced they could be punished with ten years in prison should their actions be deemed fraudulent. In Germany, Maple Bank in Frankfurt was the first casualty, after being forced into insolvency by a €300 million fine for its part in this criminality. Further investigations are ongoing throughout the World’s largest economies.
This catastrophe should serve as a warning for developed and emerging markets alike. In both cases, tax systems should remain up to date to capture the ‘fair value’ of these complicated financial transactions. A one off ‘Dividend Repat’ tax at an aggregated rate could also be introduced to ensure that firms repay previous discrepancies in order to qualify for a more competitive dividend tax rate in the future, for example. As a final note, it is important that businesses honour their fiduciary responsibility to the countries in which operate, and pay the appropriate tax.