In the wake of the cum-ex affair: Shouldn’t we stop tax systems facilitating their own exploitation?

It is hard to think of any set of tax rules in tax systems that are generally more problematic than those that deal with the taxation of financial products. This has been a problem area for decades, with banks in particular regularly exploiting the position, monetizing the inadequacies and inefficiencies in the tax system through complex tax-driven structured products. The bizarre result is therefore that functioning tax systems, in the way in which they deal with financial products,  actually create a subsidy to the banks.

There is no better illustration of just this result than in the case of the cum-ex affair. The financial product structuring involved in that case is inordinately complicated, involving multiple parties, often spread across the globe, entering into a series of separate but co-ordinated transactions involving equities trades, derivatives trades and stock lending transactions. The goal of the arrangements is simply to generate a tax benefit which arises in very specific circumstances through the interaction of the tax system and the market settlement system. The cum-ex affair involved share movements in the hundreds of billions of euros and tax losses measured in the tens of billions of euros. Hundreds of banks and investment funds were actively involved. Many funds, including hundreds of pension funds, were established for the sole purpose of participating in the arrangements.

The troubling point that emerges from both the cum-ex affair and the taxation of financial products more generally is that tax systems are not just vulnerable to being gamed but rather that they positively facilitate that result. This is exactly what I argue in my recently-published book, Banking on Failure (Oxford University Press, 2020). There are various ways in which tax systems seem literally to facilitate their own exploitation when it comes to financial products. I give three relevant examples below.

Especially in the area of financial product taxation, tax systems create deep systemic complexity that tax authorities often cannot control and police: There is in many tax systems (and especially so in the way they deal with financial products) a huge amount of line drawing, with different tax rules according to each feature or characteristics of the transaction: the attributes of the taxpayer, the type of income, and the varied legal categories of income. Distinctions such as those that exist between debt and equity, income and capital, real and synthetic income, etc. create the “opportunity set” for financial product tax structuring. Further, tax systems create value in the form of tax attributes – such as a right to a tax reclaim, or a tax credit, or a tax deduction, etc. These rights are typically designed by tax systems to be available to some taxpayers (or to attach to certain types of income or payment) but not to others. Yet the ability to control and police this situation on the part of tax authorities is often absent, or it is easily circumvented by financial product planning. In some cases, such as in the German cum-ex transactions, the tax value can even be conjured up by complex financial product planning. 

Tax systems generally still fail to get to grips with the taxation of what are often referred to as “new” or “innovative” financial products like derivatives, stock lending, and other structured or synthetic products notwithstanding that many of these have been around for at least 40 years: There are numerous examples where domestic tax systems have both failed to address the use of such products and also not fully appreciated how such instruments can routinely be used as staple tools in the tax structuring tool box – whether to replicate the economic effect of a traditional financial product or transaction yet with an entirely different tax treatment – or as a distribution mechanism to allow the sharing of tax benefits generated by tax-structured product planning. Similarly, it is twenty-five years since the OECD identified  “a great many problems” relating to the interaction of financial products and tax treaties but subsequent to that revelation almost no further work on the topic has been carried out.

Where problems are identified, the response is often very slow: This is again exemplified by the cum-ex case. In that case, successive attempts by the German tax authorities over a number of years to close the trade down not only failed to hit their target but, as argued by various commentators, by their nature actually encouraged participation in the trade. A further problem lies in the fact that when abuse is ultimately identified and pursued by the tax authorities in a state, there is little in the way of effective and efficient globally-co-ordinated mechanisms to help them pursue the transgressors on a cross-border basis. By structuring transactions so as to incorporate cross-border transactional elements, whether that be the venue of a trade execution or the residency of a legal entity, market participants can further exploit this weakness in the global enforcement regime.

The heart of the issue is that tax systems (and this is particularly true of the tax rules governing financial products) generally develop by a process of continuous piecemeal evolution, and in doing so create a high degree of systemic variability and complexity. The tax differences are not arbitraged away like ordinary market pricing differences but instead persist and provide the raw material for the financial product tax structurer. At the same time, the scale of what is required to monitor, manage and regulate such complexity is often seriously underestimated by the tax authorities. In the case of financial products, merely knowing the rules is not enough – they must be understood in the context of existing market practices and conventions, the detailed operation of settlement systems, and with a savvy and experienced eye on how they might be gamed or arbitraged. A view on current market trends and activity is also essential. The predicament from which existing tax systems suffer is one in which opportunities for exploitation are a by-product of the system itself, may be immense in their scale and may not be well recognised, if recognised at all. The cum-ex scandal amply demonstrates this. All too often, these disorders of the tax system tip the balance of advantage in favour of those seeking to exploit, rather than administer, its rules.