Cum-Ex Frauds—An Information-Delay Problem

Cum-ex, you’ve seen the headlines, you have a vague notion of it being some sort of European Union-centered financial fraud, but you’re not about to type that into a search engine. Even in the best-case scenario you’re just going to wind up reading about some boring tax dodge. No thanks! Well, fear not, here is your primer on the interesting and entirely family-friendly tax theft roiling the EU.

What is Cum-Ex?

It is Latin for with-without, and the term is a high-level explanation for the fraud itself: Shares are sold with dividend rights but delivered without dividend rights. The manner of arriving at that transaction differs slightly from country to country, but the overarching scam is the same, and thus cum-ex is an apt umbrella term.

The cum-ex fraud is a sort of evolution of an earlier scheme, the cum-cum (“with-with”) transaction, which was considerably simpler: In many EU countries, double-tax agreements serve to permit dividend withholding tax rebates for owners who are residents of countries that are party to the treaty. The cum-cum scheme just involved the lending of shares to domestic entities to permit foreign owners to receive tax rebates, with a little bit sliced off to pay the domestic entity for its trouble. In most cases, it wasn’t a fraud, per se, but a circumvention and exploitation of loopholes in the withholding tax laws.

Cum-cum illuminated a crucial loophole that would enable the future cum-ex fraud, however, which was the fact that taxing authorities have an information-delay as to ownership of a given share. Transactions enacted close to the dividend payout deadline that serve to change share ownership are difficult to confirm and thus are often just assumed to be legitimate by tax authorities.

That loophole was enlarged by cum-ex to drive a $55b truck through it.

How Does It Work?

When a dividend is paid out on a share, a withholding tax is withheld. If certain residency conditions are met, that withholding tax can be rebated. The cum-ex transaction trades on the cum-cum loophole and sees two individuals receiving withholding tax rebates for every one withholding tax payment made. The specific mechanism has some variations from country to country, but all trade on the idea of there being an information delay for the tax authority and a protracted transaction.

In Germany, for instance, when a share is sold, the sale date is followed by a three-day clearing process before the settlement date. If this three-day period between sale and clearing is set to straddle the dividend date, there is an ambiguity for the tax authority regarding who actually received the dividend. The seller will often sell the share with a contractual commitment that it is the buyer who will receive the dividend, knowing that the clearing date will not come prior to the dividend being paid out to the seller. The seller will receive the dividend and pay the necessary withholding tax, and have that evidence to present to the tax authority to receive the withholding tax rebate. The buyer also, however, will have evidence that in fact they are the owner of the shares and have a contractual right to the dividend and, thus, a right to the withholding tax rebate. The tax authority pays out the rebate on the strength of that evidence. By the time the tax authority figures out they have sent two rebates for the same withholding tax paid, the fraudsters have packed up and left.

By way of a second example, the same fraud variant in Denmark: Here, pension funds in the United States were used in conjunction with an instrument called an American Depository Receipt, or ADR. ADRs are used by entities such as pension funds in the U.S. to invest in foreign securities. They are negotiable instruments issued by the depository bank, in the U.S., evincing a specified number of shares of a foreign company’s security—they are somewhat akin to a foreign single-security index fund. The Danish fraud revolved around shares owned by U.S. pension funds being shuttled around between several banks in the EU in rapid succession around the dividend date, with each bank creating a credit advice evincing ownership. Those advices were then rapidly forwarded on to the pension funds to be used to acquire tax vouchers and corresponding rebates on dividend taxes never paid.

What Is the Common Factor?

The common element in all of these schemes is an information delay: The information regarding the true ownership of the shares is known by some parties to the transaction—the fraudsters and the banks, at least—but not by the tax authority.

The fraudsters and the banks are not truly on opposite sides of the transaction, as the banks, both the issuing banks for the dividends and the depository banks for the credit advices, are not footing the bill for fraudulent withholding rebates paid. The banks are incentivized to process the claims with minimal administrative oversight, as there is no real ramification for them if the claims are fraudulent.

The common factors are thus both information delay and a disincentive to share information between parties to a transaction.

What Are Some Potential Solutions?

Would you still respect me if I said blockchain? But seriously, maybe blockchain. It is the best solution for few problems, but it just might have found an application here. A database shared among all of the parties to the transaction, including the tax authority, would probably work just as well, however.

The keys are, first, finding a way to permit the tax authority to see at any given moment not just who has ownership, real or constructive, of a share at a given moment—but when they got ownership, how long they have had ownership, and whether there is a transaction in process involving the share. Second, being able to tie withholding tax paid to withholding tax rebates in a way that ensures a second rebate cannot be sent out once the first has been issued. Third, ensuring the clearing period for sold shares and settled shares is mirrored on the other side of the transaction by a clearing period for withholding tax rebate requests. Fourth, and finally, if the parties aren’t incentivized naturally to “check the work” of each other, the auditing must be offloaded to the technology by way of ensuring all information is shared among all parties.

The solution must not be too narrowly tailored to the problem—that is what has permitted these frauds to evolve and flourish.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Andrew Leahey is a tax and technology attorney in Pennsylvania and New Jersey.

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