Div-arb has been an open secret on Wall Street for years. It faces new scrutiny in Germany amid questions about its legality and a government push to end it.
Div-arb has been an open secret on Wall Street for years. It faces new scrutiny in Germany amid questions about its legality and a government push to end it.
German companies are known for paying some of the heftiest dividends among world stocks, one reason U.S. investment giants such as BlackRock and Vanguard are among the biggest holders of German shares.
But Wall Street has figured out a way to squeeze some extra income from these stocks. And German taxpayers pay for it.
A cache of confidential documents obtained by ProPublica and analysed in collaboration with The Washington Post, German broadcaster ARD and the Handelsblatt newspaper in Düsseldorf details how Wall Street puts together complex stock-lending deals that drain an estimated $1 billion a year from the German treasury.
Similar deals extend beyond Germany, siphoning revenue from at least 20 other countries across four continents, according to the documents, which show how "dividend-arbitrage" transactions — known in the trade as "div-arb" — are structured and marketed as tax-avoidance vehicles.
The trove of transaction logs, emails, marketing materials, chat messages and other communications among deal participants involves a who's who of the world's big banks and institutional investors.
In deals like these, some of America's largest money managers briefly lend out some of their German holdings each year. Those shares are temporarily held by German investment funds and banks that by law pay no tax on German dividends or can claim refunds for tax withheld. The borrowed shares are returned shortly after the dividend is paid.
The banks or funds that borrowed the shares receive the dividends tax-free and then transfer that money to the stocks' original owner, minus fees for middlemen. The foreign investors typically end up with added income equivalent to about half the dividend tax that would have been owed. Some firms, like BlackRock, run their own security lending programs, while others lend through big global banks that package the deals.
Vanguard, BlackRock and Fidelity said their securities lending follows applicable laws and is designed to help investors. Mike McNamee, a spokesman for the Investment Company Institute, which represents large money managers, said "funds have an obligation to maximise returns for shareholders."
Div-arb has been an open secret on Wall Street for years. It faces new scrutiny in Germany amid questions about its legality and a government push to end it.
The practice — sometimes called "dividend washing," "dividend stripping" or "yield enhancement" — is the latest version of a long-running game in which creative bankers exploit gaps and inconsistencies in foreign tax systems to benefit wealthy clients. As with corporate inversions and schemes to hide money in offshore accounts, governments lose billions and the tax burden shifts to others.
Some say governments have no one but themselves to blame. "Unless governments are going to get serious about harmonising and standardising tax rates, then governments leave themselves open to this loophole," said Josh Galper, managing principal of Finadium, a financial consulting firm in Concord, Mass.
Legal experts who reviewed trades detailed in the documents said they might cross the line because German law forbids transactions whose sole purpose is to avoid taxes — a standard that is extremely difficult to meet. Germany's highest tax court recently invalidated one div-arb transaction that it called an "empty shell."
In the United States, Congress put an end to div-arb in 2010 after a scathing report by the Senate Permanent Subcommittee on Investigations two years earlier.
Shown some of the German transactions in the cache, Reuven Avi-Yonah, a University of Michigan Law School professor who helped Senate investigators in 2008, said he believes they were "pretty clearly tax-motivated."
"Regardless of whether you have an obligation to your shareholders, that does not extend to things that you know have no motivation other than reducing taxes," Avi-Yonah said. "That's illegal under current German law."
In one email exchange, a manager of Norway's sovereign wealth fund wrote to intermediaries to confirm his understanding of a lending transaction. The purpose of the loan, he wrote, was to "avoid" a 15 percent withholding tax on shares of international companies by agreeing to a 50-50 split of the taxes saved.
"We do not necessarily know the motivation for borrowing, or who the end user is, but are aware that tax considerations are one of several drivers for pricing these transactions," a spokesman for the fund said in an email.
Sovereign wealth funds in Saudi Arabia, Kuwait and Singapore also lend shares for div-arb deals, the documents show. So do other investment managers in the United States, including Franklin Templeton and T. Rowe Price, both of which declined to comment.
Banks playing a role in such trades include Barclays, Goldman Sachs, UBS, Morgan Stanley, Citigroup, Merrill Lynch, JPMorgan, Deutsche Bank and Swedish bank SEB, among others, the documents show.
All the banks declined to comment except for Deutsche Bank and SEB, which said their transactions abide by all applicable laws and regulations.
In Germany, the most prominent participant is Commerzbank, which was bailed out by German taxpayers during the financial crisis and is still 15 percent owned by the government. Commerzbank declined multiple requests for comment.
For German lawmaker Gerhard Schick, deputy chairman of the Parliament's finance committee, the irony stings. "Personally as a taxpayer, I feel as if somebody was pulling my leg when I found out banks that we rescued do trades at our expense," he said.
"This is a no-go."
Div-arb is a big deal in Germany. A ProPublica analysis of five years of stock lending data for companies on the DAX 30 — the German equivalent of the 30-stock Dow Jones industrial average — shows that the number of borrowed shares typically climbed 800 percent in the 20 days preceding the dividend record date. That's when companies identify shareholders who will get paid dividends.
Twenty days after the record date, borrowings returned to prior levels, according to share lending volume tracked by Markit for S&P Global Market Intelligence, which provided the data for ProPublica's analysis.
The annual spikes in borrowing are as regular as blips on a heart monitor. By contrast, the number of borrowed shares of the Dow Industrials barely budges around dividend record dates.
There are no official statistics about the tax impact of div-arb. To estimate the annual loss to the German treasury, ProPublica calculated dividends paid by each DAX 30 company on the increased volume.
That amount comes to about $6 billion a year. Other German stocks pay an additional $600 million or so. Based on a typical tax rate of 15 percent for foreign owners, the combined loss is $1 billion for the German treasury.
A key feature of the div-arb transactions is the absence of risk for borrowers and lenders. The terms are hedged and arranged months in advance, documents show. Lenders know when their shares will be loaned out, at what prices, and when they'll come back. Collateral backs the loans in case borrowers run into financial problems.
Here is how it worked for one trade on May 7, 2014.
In a deal brokered by Morgan Stanley, which found tax-exempt borrowers, Vanguard loaned out 95,000 shares of Adidas, which was due to pay a 1.5 euro-per-share ($2.19 a share) dividend two days later — a total of 142,500 euros, or about $196,000 at the currency conversion rate at the time.
In Germany, the most prominent participant is Commerzbank. Photo / Getty Images
Had Vanguard held the shares on the record date, it would have had $29,400 withheld for tax. But by shuffling the shares to a tax-exempt party in Germany, Vanguard was able to get an extra $12,700 for its investors; the remaining $16,700 was shared with Morgan Stanley and other players.
The Adidas shares came back five days later, netting an annualised yield of 9 percent on the loan for Vanguard's investors, ProPublica calculated.
To turn thousands of such small, riskless trades into more substantial profits, bankers package them into billion-dollar baskets.
The Adidas transaction was one of hundreds of such loans made by Vanguard mutual funds totaling more than $1 billion across several dozen stocks. Most were German; the remainder included companies from Austria, Belgium, Canada, Denmark, Italy, the Netherlands, Portugal and Switzerland.
The companies paid $31 million of dividends on Vanguard's holdings in May, June and July of 2014. Trade logs show that the Vanguard funds would have netted an average of 81 percent of those dividends had taxes been withheld. Instead, Vanguard got 90 percent, or $3 million more.
Vanguard declined to discuss any individual trades. "Securities lending is a widely accepted practice that we prudently employ to augment fund returns to the benefit of our clients," company spokesman John Woerth wrote in an email.
Woerth said any "insinuation that this is a tax dodge is incorrect" because stock borrowers are responsible for paying local taxes. "We are not privy to information about the end securities' borrowers, their tax situation in Germany, and what, if any, type of profit they may earn as a result of borrowing over a dividend record date," he said.
Woerth said Vanguard receives a "securities lending fee" from the deals, along with a "dividend equivalent payment."
The banks involved in the various Vanguard share loans, besides Morgan Stanley, were Goldman Sachs, Barclays, JPMorgan, Merrill Lynch and Citigroup. The banks all declined to comment.
For the div-arb deals to work, shares must be loaned to a German fund or bank that doesn't face withholding taxes or can file for a refund if they are withheld. The trading logs don't identify those entities. But in the Adidas deal, share ownership data from BaFin, Germany's securities regulator, offers a clue about Commerzbank's possible role.
The bank normally isn't a large holder of Adidas stock. But on May 7, it reported to BaFin that it owned 4.32 percent of Adidas — about 9 million shares — that made it a top Adidas shareholder in line for $18,792,000 in dividends.
Assuming that a 15 percent tax would otherwise have been paid, the German treasury lost $2.8 million.
By May 20, post-dividend, Commerzbank's holdings of Adidas were back to zero. The swing was not an isolated case. From 2013 and 2015, BaFin records show nearly 250 similar spikes in Commerzbank holdings of individual stocks. About 80 percent of the swings occurred at the time of dividend record dates, an ARD analysis found.
Commerzbank is identified in email exchanges as a provider of "end user" funds where loaned German shares can be placed without being taxed.
Commerzbank declined to comment on its role in the deals. Chief executive Martin Blessing was asked about div-arb at the bank's recent annual meeting. Blessing, whose contract expired May 1, said the bank handles more than 100,000 transactions a day with thousands of participants.
While acknowledging that some transactions occur around dividend dates, he said the bank's auditors ensure that "all transactions are in compliance with the law."
Investment firms say they lend shares to benefit their clients and won't discuss why demand spikes around dividend times, but the documents offer some explanation.
Marketing materials from one bank identify the trades as a "risk-controlled" way for investors who "suffer" taxes to "recapture" dividends that are withheld.
Another bank prepared an explainer for clients that says, "We're not going to pretend to be tax experts, but it goes something like this." The explainer then details how investors can avoid taxes by lending shares over dividend dates.
In one set of messages, a senior securities lending executive at Vanguard gave an intermediary permission to lend out shares of an international stock for "the dividend yield enhancement trade."
In another case, Commerzbank emailed another party in one deal asking to renegotiate after learning that a portion of the dividend would be tax-exempt. That would reduce the tax benefit of the transaction.
Accounts of meetings show that at least some firms backed off trades. One document describes Goldman Sachs bankers saying their traders abandoned certain deals in 2013 because of increased internal scrutiny of div-arb. Goldman Sachs declined to comment.
In another document, a senior banker cites "reputational concern" as a reason for flagging demand for div-arb trades. Despite the concern, the banker said traders on his team continued to be "proactive" and "push" out baskets of loans over dividend record dates.
Reputational concerns appear to have motivated some German banks to stay away from div-arb. Nord/LB, for one, said its policies forbid div-arb deals.
Trying to shut it down
New attention to div-arb by German regulators and lawmakers is the byproduct of a recent scandal involving trades in which participants had been claiming duplicate refunds of dividend taxes.
Those deals, known as "cum/ex" trades, were outlawed by Germany in 2012. Regulators are now moving to claw back the refunds from German banks. But the law didn't address deals like Vanguard's loan of Adidas shares, called "cum/cum."
Last August, Germany's Federal Fiscal Court — the equivalent of the U.S. Tax Court — struck down a div-arb deal involving an unidentified British financial institution and a German company. The court found that there was no transfer of economic ownership because, among other things, the borrower bore no risk.
A tax official in one state, Baden-Württemberg, has said the court ruling implies that similar deals may not hold. Reporters contacted officials in each of Germany's 16 states to ask if they were investigating div-arb; four said they had found evidence of questionable transactions but declined to elaborate.
Now, the government is trying to shut down div-arb for good. Pending legislation would force temporary share owners to hold a stock for at least 45 days and to have at least 30 percent of a stock's value at risk, restrictions that would make the deals uneconomical. Australia adopted a similar change to halt the practice there.
In the United States, it took the Foreign Account Tax Compliance Act of 2010 and aggressive rules from the IRS to halt div-arb, which had existed in a variety of forms since at least 1991.
Elise Bean, who as subcommittee chief counsel helped lead the Senate's investigation in 2008, said other countries have their work cut out for them.
Documents in the cache indicate that bankers book div-arb trades in France, Canada, Italy, Japan, Sweden, Switzerland, Netherlands, Israel, Hungary, Singapore, Norway, Denmark, Finland, Belgium, Austria, Czech Republic, Poland, Portugal, Spain and South Africa. They are also on the lookout for new markets.
"Everybody and their brother was doing it in the U.S.," Bean said. "And I guess now everybody and their brother is doing it abroad."
