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A Closer Look

A Schlupfloch Here, a Schlupfloch There. Now It’s Real Money.

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A Closer Look

Examining the news

Allan Sloan

I’ve written about tax loopholes for decades. But recently, I wrote about Schlupflöcher for the first time, in a venture that shows how journalists can be as multinational as investment banks. We just make a lot less money.

What does Schlupflöcher mean? I’m glad you asked. It’s German for “loopholes.” Which is the topic that Cezary Podkul of ProPublica and I wrote about last week. We showed how German tax law allowed American mutual fund investors, American fund companies and (naturally) American investment banks to all profit at the expense of German taxpayers.

Podkul and I conservatively estimated the revenue loss to the German treasury (and the gain to everyone else) at about $1 billion a year, but tax mavens in Germany whom I talked with after our article appeared think that the real number is $3 billion, if not more.

This particular tax game, “dividend arbitrage,” is played in more than 20 countries, with Germany by far the biggest market.

Podkul and I decoded dividend arbitrage by using confidential documents that ProPublica obtained, and by going multinational and coordinating research with German broadcaster ARD and the Handelsblatt newspaper in Düsseldorf.

Our German partners — including Pia Dangelmayer of ARD, who was a Burns fellow at ProPublica’s New York headquarters — handled much of the German reporting. Podkul and I worked the American end.

Serving our differing markets, Podkul and I wrote a U.S.-centric version for The Washington Post and ProPublica, while ARD and Handelsblatt stressed how Commerzbank, rescued by German taxpayers during the financial crisis, was helping drain revenue from the German

treasury. Podkul and I found the irony of the Commerzbank connection irresistible, but we didn’t dwell on it. Or on the fact that the German government still owns 15 percent of Commerzbank and has two seats on its board.

As a result of the uproar stirred by our partners’ coverage in Germany, Commerzbank promptly promised to stop doing dividend arbitrage in Germany and elsewhere. “Div-arb,” as it’s known, is now being denounced publicly in Germany. Legislation that would make the div-arb game too risky and expensive for German institutions to play now seems likely to be enacted reasonably soon.

If you’re not a German taxpayer — which I’m not, and most of the people who read this aren’t — should you care about any of this? Absolutely.

First, the tale of how dividend arbitrage works and how we unraveled it in a multinational way shows how strange and wonderfully convoluted the world can be. Second, you can bet that the strategists who devised dividend arbitrage are exploiting the U.S. tax system in ways that we just haven’t found yet.

I’ll give you the short version of how dividend arbitrage works in Germany, because even thinking about the long version makes my teeth hurt.

Dividend arbitrage — which was knocked out in the United States by tax law changes in 2010 — works in Germany because taxes are withheld on the dividends German companies pay, and because German tax law treats different shareholders in different ways.

Some shareholderswho pay German income tax can get credits for withheld dividend taxes, or even get refunds. Other shareholders, like sovereign wealth funds or U.S. mutual funds that don’t pay German income tax, have to kiss that withheld tax goodbye. The taxes range from 15 percent for U.S. funds to 25 percent and more for certain other investors.

So middlemen enabled shares of German companies to migrate briefly from holders who can’t use credits generated by the withholding tax to those who can. The long-term holder, the short-term holder and the deal makers combine to carve up the withheld tax, leaving nothing for the German treasury.

Wall Street Stock Loans Drain $1 Billion a Year From German Taxpayers

Carefully timed deals help big money managers skirt dividend taxes in 20 countries, confidential documents show. Read the story.

How Div-arb Works

Here’s how big investors shuffle shares around to avoid paying the tax. Learn more.

In the transactions that Podkul and I dissected, the long-term holder got about half the pot, the other players got the rest.

Because of public outrage and corporate embarrassment provoked by journalists obtaining access to confidential documents, one Schlupfloch (the singular for ‘loophole’) in Germany seems on the way to being closed. With luck, the same will happen in some of the other countries where dividend arbitrage is still under way.

I would like to think that someday U.S. taxpayers will become as outraged as German taxpayers have become and that corporate players and their enablers will be as embarrassed as their German counterparts.

If enough anger and embarrassment ensue, maybe we can close notorious U.S. loopholes such as “carried interest” (which lets some money managers pay lower, capital gains taxes on their share of investors’ profits) and “corporate inversion” (which lets corporations desert the United States for tax purposes while remaining here to benefit from what our country has to offer).

I’m not counting on that happening. But a year or two ago, no one was counting on the dividend arbitrage loophole in Germany being closed. German taxpayers lucked out. Maybe U.S. taxpayers can, too. And on that note, I bid you, “Auf Wiedersehen.”

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