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The latest tax developments Issue 1, October 2014

Banking & Capital Markets Tax Newsflash

BFH judgement on the transfer of beneficial ownership in structured sell/buy-back stock transaction over dividend record date The German Federal Fiscal Court (BFH) has handed down its long awaited judgment – file no. I R 2/12 - on a structured sell/buy back transaction over dividend record date. The reasoning of the judgement was expected to shed some light on the tax treatment of the controversial “cum/ex” transactions.

Guiding Principles The court has stated the following guiding principles: •

Income from capital investment is attributed to the shareholder who either legally or beneficially owns the underlying stock on the date where the general assembly of shareholders votes on the payment of dividends (“dividend record date”).

•

Beneficial ownership does not pass to the purchaser of stock if the purchase is embedded in a contractual framework whereby the purchase is financed by the bank who initiated the transaction, the purchaser on-lends the stock to the bank immediately after the purchase until sell-back and the market risk of purchaser on the stock is hedged with bank by way of a total return swap.

Facts The facts of the case are somewhat intricate: In essence, the German domiciled plaintiff, a limited liability company (GmbH), bought stock from a UK broker, acting “as matched principal”, i.e. hedged by a matching purchase contract with an undisclosed third party. At the time of purchase, the stock was in custody of a French bank. The reported facts do not reveal, however, whether the stock was held in the name of the UK broker or the undisclosed third party on the date of purchase. The transaction was initiated and financed by a UK resident bank (UK-Bank) who financed the purchase of GmbH. On dividend record date, UK-Bank and GmbH entered into a stock loan agreement and a total return swap according to which GmbH swapped the market (price) risk on the stock to UK-Bank.

Banking & Capital Markets Tax Newsflash

The stock loan was settled on the date of the payment of the dividends on the underlying shares (“ex-date”). On ex-date, GmbH received a manufactured dividend from UK-Bank 95% of which was paid by GmbH to UK-Bank under the total return swap. Post ex-date GmbH sold stock of the same kind (“equivalent stock”) to the UK broker. A simplified diagram of the transaction is shown below:

Banking & Capital Markets Tax Newsflash

Summary of Reasoning The reasoning of the BFH may be summarized as follows: •

Referring to older case law, the court confirmed that beneficial ownership may pass to the purchaser prior to the stock settling into purchaser’s security account – i.e. prior to him acquiring legal title. This would require that, based on the terms of the sales contract, the purchaser is entitled to claim dividends, on-sell the stock and bears full market risk and such rights may not be invalidated by the seller in the ordinary course of the transaction, i.e. until the underlying stock settles into purchaser’s security account (“beneficial ownership test”).

•

The court explicitly confirmed, that this beneficial ownership test also applies to OTC purchases of stock. A position disputed by the German tax authorities.

•

In the case at hand, the court decided that GmbH did not pass the beneficial ownership test as the combination of all contracts between UK-Bank and GmbH substantially precluded purchaser from effectively exerting or benefitting from shareholder rights.

Relevance for future and pending “cum/ex” cases At first glance, the relevance of the judgment for future “cum/ex” cases is limited as the court explicitly did not decide whether the “beneficial ownership test” applies also in cases where the seller was not legal or beneficial owner of the underlying stock on trade date (so-called short sales). However, as an obiter dictum the court noted that the relevance of potential short sales might be overstated in light of the set-up of “cum/ex” trades as currently described in technical and non-technical articles. The court’s statement seems to imply that where there are “packaged” transaction, i.e. a combination of contracts, as a consequence of which the purchaser is substantially precluded from benefitting or exercing shareholder rights and not exposed to market (price) risk beneficial ownership does not pass to the purchaser even if the seller had legal title to the underlying stock on trade date. In practice, “cum/ex” trades were usually “packaged” transactions, i.e. structured as a combination of a sales contract and at least one other financial instrument such as a derivative to hedge out market risk on the underlying stock. In this respect, the judgement states that an individual leg of a transaction that would in itself not prevent the transfer of beneficial ownership – e.g. hedge agreements without a physical delivery of stock – becomes relevant only where there are additional features that would substantially limit the purchaser in benefitting from and/or exercising shareholder rights. Important legal questions still open The judgement of the BFH is very much based on the merits of the tried case. It does not provide guidance beyond the legal analysis of the facts laid out before the court. Thus, a number of important legal questions relevant to pending “cum/ex” cases are still open, such as: •

How is the beneficial ownership test applied where there is a combination of contracts with different counterparties?

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If there is no “packaged transaction” but uncertainty as to whether the seller was short selling:

Banking & Capital Markets Tax Newsflash

•

Does beneficial ownership “double-up” in cases of short sales, i.e. does the purchaser acquire beneficial ownership even if the seller was neither legal or beneficial owner of the underlying stock on trade date?

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If there is no “doubling-up” of beneficial ownership who bears the burden of proof that the seller of the stock was not short selling? Is there a difference between purchases via a stock exchange and OTC?

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Related to “cum/ex” trades as of FY 2007: Does the receipt of a manufactured dividend suffice to claim a withholding tax credit as long as purchaser did acquire legal and/or beneficial ownership post dividend record date?

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Finally, if there was no “packaged transaction” and the seller was (beneficial) owner of the underlying stock on trade date is there any room to apply German general anti avoidance principles (GAAR)?

Given these open issues it is not hard to predict that this will not be the last judgement handed down by the BFH on “cum/ex” trades. On the other hand, the judgment of the BFH reported herein seem to confer a certain discretion to lower financial courts to decide on the allocation of beneficial ownership based on its understanding of the factual circumstances of each case. Such an understanding might not be subject to appeal to the BFH.

Banking & Capital Markets Tax Newsflash

Contacts Düsseldorf Achim Obermann Tel.: +49 211 981-7358 [email protected]

Hamburg Jörg Winkler Tel.: +49 40 6378-8407 [email protected]

Frankfurt am Main Dr. Christian Altvater Tel.: +49 69 9585-6909 [email protected]

München Ulrich Ammelung Tel.: +49 89 5790-6270 [email protected]

Jürgen Kuhn Tel.: +49 69 9585-5779 [email protected] Herbert Zerwas Tel.: +49 69 9585-6812 [email protected]

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