Look to Denmark for How to Tackle Fraudulent Arbitrage Schemes

It is notoriously difficult to enforce taxation on dividends. Abuse of dividend withholding tax reimbursement systems through arbitrage is common in the US and Western Europe.

A recent estimate from Christoph Spengel, professor of international taxation at the University of Mannheim, places revenue losses through these types of arbitrage at 150 billion euros ($165 billion) across the US and 11 European countries over the last two decades. During a hearing at the European Parliament, he called it the “biggest tax robbery in European history.”

If ever there was a time to bear down on DWT arbitrage, it is now. The European Commission has signaled its commitment to harmonize DWT and reimbursement systems across its member states.

The Reform

Our analysis looks at a Danish reform brought into force in 2016 as a possible model for new methods of enforcing the DWT. In the study, we consider the effect of the reform on DWT arbitrage, Danish tax revenue, and behavior of investors and Danish companies. We found it was highly effective at cracking down on arbitrage through cum-cum and cum-ex schemes, with a large increase in DWT revenue, and only a short-term negative impact on Danish firms.

Tax authorities in Denmark discovered large-scale dividend arbitrage transactions that exploited the DWT reimbursement system in 2015. We estimate these illicit transactions cost the country around $1.3 billion per year in revenue losses.

The authorities responded by changing documentation requirements to make sure organizations that apply for reimbursements are eligible. Our analysis reveals that this led to a 130% increase in annual DWT revenue.

Looked at more closely, DWT arbitrage schemes work in different ways. In cum-cum transactions, a foreign investor agrees to lend its shares to a domestic institution (often a bank) shortly before the dividend record date. This allows them to benefit from DWT relief that would normally only be given to domestic investors. In cum-ex transactions, shares are sold short before the dividend record date but delivered after the date has passed. This can trigger a tax reimbursement twice, even though the tax is effectively paid only once.

Because both types of transaction rely on stock lending, the number of stocks on loan spikes sharply just before pay-out dates. They are clearly visible when investigators look at the raw data, and we find that after Denmark brought in tighter enforcement of the DWT, these spikes disappear.

Clearly, the reform has taken a significant stride in the correct direction by making it more challenging for investors to engage in DWT arbitrage, resulting in a substantial surge in government revenue.

However, policymakers face a dilemma. When they make it more burdensome to provide documents, foreign investors might be less interested in investing in local companies. Our analysis does reveal a reduction in investment after the change, but the effects were only temporary. The firms most affected were those that suffered liquidity constraints prior to the reform, meaning those firms that use equity as the main source of financing for new investments. These firms suffered a short-term moderate reduction in investment, though we find no negative effects in the long term.

We also found the new documentation requirements didn’t trigger any significant changes to companies’ dividend policies. In short, most of the reform’s negative side effects are short-term and contained.

This is by no means an isolated example. The stricter enforcement introduced in Germany, also in 2016, had similar results. We find the spikes in stocks on loan around dividend pay-out dates disappear entirely. The same pattern was repeated in Austria after a reform in 2018.

Useful Lessons

The Danish reforms offer a number of useful lessons for policymakers.

• First, stricter enforcement of the DWT can lead to a massive surge in revenue.
• Second, imposing a higher burden of documentation in reimbursement systems is not necessarily doomed to dry up the pool of foreign investment for domestic firms.
• Third, the reform’s contained and targeted approach was a key strength. It doesn’t restrict other forms of legal arbitrage.
• Fourth, it’s crucial for tax authorities to establish the true owner of an asset if they are to eliminate the possibility for cum-cum and cum-ex transactions.

That said, tax authorities can’t afford to relax. The future will see new channels emerging through which investors will attempt to sidestep the cost of the DWT. Properly enforcing the tax on dividends is a complex task, as the capital is highly mobile.

So, is the Danish reform a viable model for other countries? Yes and no. There is no one-size-fits-all solution for every country affected by arbitrage schemes. The scale of the problem varies from region to region—for instance, it’s much less prevalent in Southern Europe and Ireland.

However, the Danish case offers an important lesson. As the European Commission aims to standardize reimbursement systems throughout Europe, it is crucial to ensure that these systems provide enough information to tax authorities. This information should enable the tax authorities to track publicly traded stocks back to their rightful owner. Only by implementing such documentation requirements can the authorities effectively enforce tax compliance regarding DWT.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Elisa Casi, Evelina Gavrilova and Floris Zoutman are assistant professors at the NHH Norwegian School of Economics.

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