In a two-part article, tax experts speak to Bob Currie about how tax reforms are impacting securities financing markets and how tax authorities are acting to eliminate the risk of tax abusive schemes
Tax authorities are stepping up their efforts across a number of European jurisdictions to eliminate dividend tax reclamation fraud and to seek recovery of funds lost through cum-ex and cum-cum trading.
In June, the UK Financial Conduct Authority (FCA) brought its largest-ever cum-ex-related enforcement action, imposing a £17.2 million fine on the now-closed ED&F Man Capital Markets for aiding clients to claim illicit tax rebates from Danish tax authorities between 2012 and 2015.
Niall Hearty of London-based law firm Rahman Ravelli explains that, according to the FCA, ED&F Man Capital Markets helped clients — that were mostly US pension funds — to reclaim £20 million in tax on dividends from shares that they never owned or paid taxes on. “This is the latest big money development in the share-selling practice known as cum-ex, but few observers would bet on it being the last,” comments Hearty.
Securities Finance Times provided a comparative review of measures being taken by tax authorities and policymakers to combat dividend tax reclamation malpractice in SFT Issue 299, published on 29 March 2022.
Meera Khosla, chair of ISLA’s Tax Steering Group, explains that since the European Securities Market Authority (ESMA) and the European Banking Authority (EBA) launched investigations into such schemes — and directed member states to implement appropriate legislative and supervisory responses to such schemes within their respective legal frameworks — a plethora of legislation has been introduced with the objective of targeting tax abusive transactions that have the aim of avoiding withholding taxes.
“This requires participants to implement robust tax governance frameworks aimed at identifying, mitigating and reporting potential tax abuses,” says Khosla. “Abusive cum-ex and cum-cum schemes have clearly got the attention of regulators and banks are expected to have adequate controls in place to manage such risks.”
ISLA’s director of regulatory affairs Farrah Mahmood indicates that there have also been significant operational changes to the European settlement infrastructure including, but not limited to, the launch of the European Central Bank’s TARGET2-Securities centralised settlement platform, changes to the way market claims are processed and, most recently, the publication of European Commission’s proposal for a Directive on Faster and Safer Relief of Excess Withholding Taxes. This directive aims to simplify and digitalise withholding tax relief processes, but may also be seen as a response to the constant stream of media and European Parliament attention around cum-cum and cum-ex fraud schemes.
Targeting dividend tax reclamation fraud
On 15 February 2023, the French tax authorities published two public rulings relating to the withholding tax (WHT) treatment of manufactured dividends paid by French banks to non-residents. According to international law firm Clifford Chance, these changes substantially widen the legal scope of French dividend withholding tax rules, broadening their reach to dividend-equivalent payments made under temporary acquisitions of French equities and delta-one derivatives transactions with an underlying in French equities.
Dividend income paid to a non-resident is typically subject to WHT at a rate equivalent to the French corporate tax rate of 25 per cent. However, dividends paid to non-residents in jurisdictions which do not have a double taxation treaty with France are subject to the higher withholding tax rate of 75 per cent.
From 1 July 2019, the French tax authorities introduced a specific “anti-abuse rule” against dividend arbitrage trades relating to stock lending arrangements when the temporary transfer of securities is for a holding period of less than 45 days.
Under these rules, non-residents may apply for a refund of WHT paid on dividend payments providing that the transaction was not conducted, as “its principal purpose and effect”, to obtain a tax advantage or to avoid payment of French WHT.
Prior to the introduction of this anti-abuse law, payment of dividend-equivalent payments, or ‘manufactured dividends’, to a non-resident beneficial owner did not trigger an obligation to pay withholding tax on the proceeds.
However, in the first of these public rulings, the French tax authorities sought to extend WHT application to dividend-equivalent payments. It rules that WHT will now be applicable not only to a situation where a bank pays actual dividends linked to ownership of French equities, but also when the bank passes on dividend-equivalent payments to a non-resident (i.e. in cases where the actual dividend has not been paid directly to the bank).
In a second ruling, the French tax authorities also broadened the scope of the anti-abuse rule to derivatives transactions where the underlying is a French equity. In doing so, the anti-abuse rule now also captures dividend tax reclamation fraud propagated through “synthetic” derivatives-based positions.
Critics have raised concerns about uncertainties and inconsistencies in how sections of these tax rules are currently written. With regard to temporary transfers of French equities involving non-residents, for example, the French tax authorities have stated that the transaction will not be subject to WHT provided that the transaction does not involve any benefit for the bank or a related party.
However, seemingly in conflict with this position, it subsequently states that temporary acquisitions of French equities will be subject to WHT when employed for hedging short-sales positions or even when the acquiring entity wishes to build its inventory. This is the case, say the authorities, even when the lender or seller of French equities does not seek a tax benefit.
Clifford Chance partners Alexandre Lagarrigue, Eric Davoudet and Alexios Theologitis observe that these tax rulings, and particularly the generality of their terms, raise important questions regarding their scope and their legal grounds. They conclude that these proposed changes may require additional tax compliance and monitoring to ensure that WHT reporting, and other associated tax obligations, are made when required.
ISLA wrote to the French Ministry of Finance earlier this year emphasising that policy changes that discourage or curtail securities lending activity could have serious implications for financial trading activities, market making, hedging and other financial risk management activities.
In the absence of a liquid securities lending market, participants may be forced to buy back securities in the stock market to close short positions, causing short-term volatility and market disruption, thereby inhibiting price formation. Additionally, if market makers find it difficult to borrow stock, this may cause bid-offer spreads to widen and the risk of settlement failure to increase, resulting in higher trading costs and potential fines under the settlement discipline regime of the Central Securities Depositories Regulation (CSDR).
Tackling dividend tax reclamation fraud in Austria
In Austria, the Ministry of Finance also introduced a series of tax reforms in 2022 and 2023 designed to prevent tax abusive transactions that have the aim of avoiding withholding taxes. While supporting the commitment of the authorities to eliminate this malpractice, market participants and trade associations have raised concerns that these changes (particularly the November 2022 changes, see below) have, in some cases, resulted in inconsistent tax rules, problems of interpretation or they have contributed to a reduction in lendable supply in securities lending markets.
Prior to the November 2022 changes, withholding tax treatment of dividend payments to non-residents was guided principally by tax information issued by the Austrian Ministry of Finance in 2014 (the BMF Information 2014). Under this framework, dividend attribution in the Austrian market from a tax perspective arose to the person or entity who held the settled position as at close of business on the day before ex-date (Ex -1).
In terms of its impact for securities lending intermediaries, agent lenders — when instructed — typically arranged for the stock to be recalled prior to the Ex-1 date to ensure that the non-resident lender would be entitled to a withholding tax refund if applicable.
Alternatively, agents applied a restriction on the return of that stock from the borrower around the key dividend dates and the borrower would instead agree to pay a manufactured dividend to the lender. This manufactured dividend was set at a level which compensated the lender for the loss of right to reclaim WHT.
BMF Information 2022
In July 2022, the Austrian Supreme Administrative Court published a decision that determined that the person who is the beneficial owner at the time of the resolution of a dividend (i.e., AGM date), is entitled to a refund of withholding tax (see Box below).
Austrian Supreme Court decision of July 2022
In July 2022, the Austrian Supreme Administrative Court published a decision that determined that the person who is the beneficial owner of shares on AGM date is entitled to a refund of withholding tax.
The case related to a claim by a company based in the United Arab Emirates (UAE) which had bought Austrian shares cum-dividend, with the trade settling after Ex-1 and the record date. The company received a dividend compensation payment and argued that it was entitled to a refund of WHT as the cum-dividend owner. However, the Federal Fiscal Court rejected this claim and upheld the requirement of the BMF’s Information 2014 with regards to who was entitled to the WHT refund, specifically that it is the holder of the settled shares on Ex-1 that is entitled to a WHT refund.
As a result of the Supreme Court decision, the BMF issued a statement in November 2022 (the “BMF Information 2022”) confirming that the share dividend is attributable to the person who is the beneficial owner of the shares on the AGM date.
To fulfil this condition, trades conducted in the run up to the AGM must be settled and registered in the purchaser’s securities account by close of business on the business day before the AGM (AGM-1). If settlement has not been completed by this deadline, the seller will be deemed to be the beneficial owner and therefore eligible for the dividend payment.
Significantly, the changes introduced through the BMF Information 2022 also applied retrospectively, being applicable to dividend payments already made prior to the publication of the Supreme Court's decision.
Reduction in loan supply
Following the enactment of these changes under the BMF Information 2022, ISLA identified a negative impact on liquidity in securities lending markets in Austria, manifested most obviously in a contraction in lendable supply. According to the Association, this had prompted agent lenders to recall Austrian equities that were previously on loan and to limit new lending activity in Austrian shares.
Drawing on market data provided to ISLA by S&P Market Intelligence, ISLA indicates that this has resulted in a 47 per cent YoY contraction in the lendable supply of Austrian securities, with lendable value falling from US$19.958 billion on 31 December 2021 to US$10.522 billion on 31 December 2022.
On consulting with agent lenders, ISLA identifies several reasons why some agents have reduced or suspended lending activity in the Austrian market. The first is linked to operational considerations. Agent lender systems are typically set up to monitor the record date for dividend entitlement, in line with market practice globally, and may not be currently equipped in Austria to track the AGM date for WHT purposes (although they may be tracking AGM dates for reasons not directly linked to their tax operations, for example to enable proxy voting or to support clients’ ESG strategies). Banks indicated that updating tax and corporate actions systems to align with the new tax procedures would involve significant cost and operational overhead, especially where the AGM date in Austria is a variable date and can potentially fall up to 30 days before the record date for dividend payments.
Third, ISLA finds that the retrospective application of the rule changes in BMF Information 2022 also prompted some agent lenders to discontinue lending. “Investors who had prudently instructed that cum dividend stock on loan was returned prior to the Ex-1 date, are now having their withholding tax reclaims challenged when they had a legitimate expectation at the time that they would be entitled to a withholding tax refund, based on the BMF Information 2014,” ISLA explains in a letter sent to BMF, dated 21 February 2023.
On this point, ISLA emphasises that the securities lending market functions optimally through lenders and borrowers having a clear understanding of their rights and obligations under the loan agreement.
Austrian Tax Amendment Act 2023
Subsequently, the Austrian government published legislation relating to WHT treatment of dividend income. In a change to the BMF Information 2022, the Draft Bill specifies that dividend entitlement paid on shares will be attributed to the owner of the share on close of business on record date for dividends paid after 30 June 2023.
To be eligible to reclaim WHT on its dividend income, the shareholder must also meet two further criteria: it must bear adequate economic risk of the shares; and it must have held the shares for at least a 45-day minimum holding period prior to and following record date. These two additional criteria will be waived in cases where the transaction does not lead to a tax advantage.
“Adequate economic risk” requires the shareholder to bear the risk that the share price may decrease by at least 70 per cent.
Responding to these changes, ISLA has welcomed the change from AGM-1 date to settled position on record date as the date for calculating dividend entitlement. These changes become applicable from 30 June 2023 and, unlike the BMF Information 2022, do not apply retrospectively.
However, ISLA indicates that borrowers in securities lending transactions will not typically be in a position to satisfy the economic ownership criteria since they do not take price risk on the shares — except in instances of default — since the securities remain on the lender’s balance sheet throughout the loan term.
The Association has also highlighted the need for further clarification around the 45-day minimum holding requirement — for example, whether this applies per group level entity or for each single account, and whether this should be accounted on a last-in-first-out (LIFO) or first-in-first-out (FIFO) basis.
Kholsa notes that these two points have become less important with the introduction of the caveat specifying that these requirements fall away where there is no tax advantage. “The problem now for the industry is understanding what the Austrian tax authority will deem to be a tax advantage,” she says.
More broadly, ISLA understands that the additional requirements are based on anti cum-cum rules stipulated in the German Income Tax Act. “[We] would like to note that the German Rules are prescriptive and are strictly limited in their scope to German residents and certain non-German resident taxpayers who benefit from a WHT rate of less than 15 per cent under a double tax treaty,” says ISLA in its consultation response.
The Association adds that, in Germany, market participants have identified a sharp decline in lendable supply before and after the record date owing to the 45-day German minimum holding period and the operational challenges of applying the FIFO accounting methodology to evaluate this consideration in the German market.
SFT will consider other ongoing tax developments in Europe — including the European Commission’s proposal for a Financial Transaction Tax and ongoing dialogue in the UK relating to UK Stamp Tax — in the second part of this article in SFT Issue 334.
