Last September, France’s Credit Agricole bank agreed to pay a penalty of €88.2 million (CAD$142 million) to settle a criminal investigation into dividend arbitrage trades. French authorities said these trades allowed the bank to avoid paying millions in taxes. Months earlier, Britain’s financial watchdog fined investment services firm Mako £1.7 million (CAD$3.1 million) for the same thing.

These and many similar cases have pushed a little-known trading strategy into the spotlight.

Dividend arbitrage itself is not illegal and has long been used by pension funds and other large investors. But European governments now argue that it has drained billions in tax revenue.

So what is dividend arbitrage and why the controversy?

Susan Christoffersen, dean of the Rotman School of Management and a professor of finance, studied the trading strategy long before it came under scrutiny. In 2005, she co-authored one of the first research papers examining how fund managers used cross-border dividend arbitrage to reduce withholding taxes on shares held by foreign investors and showed that the strategy was in fact used to mitigate the inefficient tax effects of mixing taxable and nontaxable accounts in mutual funds. Below, she helps explain how it works, and what types of dividend arbitrage governments are challenging, and what it means for investors.

What is dividend arbitrage?

Dividend arbitrage is a complex trading strategy built around a dividend payout.

There are two basic types of dividend arbitrage. The first takes advantage of price changes on the dividend record date — that is, the date by which an investor has to own shares to be eligible for a dividend payout.

Typically, Christoffersen says, a company’s share price falls on a dividend record date, because an investor buying a share after this date no longer is eligible to receive the dividend payment.

Consider a company whose stock is trading at $100 and it pays a $1.00-per-share dividend. After the dividend record date, the stock might fall to $99.50.

Here’s how dividend arbitrage works in that case: “Before the dividend is paid, investors buy the stock at $100,” Christoffersen explains. “They receive the $1.00 dividend and then sell the stock at $99.50. They lose $0.50 on the stock sale but gain a dollar from the dividend, leaving a $0.50 profit less whatever taxes might need to be paid.”

That, she says, is the classic form of dividend arbitrage — and it’s legal.

The second type of dividend arbitrage is cross-border dividend arbitrage where foreign investors are trying to avoid paying a withholding tax. Many countries, including Canada, impose a withholding tax on dividends paid to foreign investors. (Domestic entities holding domestic securities are not subject to withholding taxes.) So, for example, if a Canadian company pays a $1.00 dividend to a U.S. investor, the government of Canada could withhold $0.15 for tax purposes, Christoffersen explains.

Some non-taxable investors can later reclaim that tax. For instance, pension plans are often exempt from taxes, meaning they are generally entitled to recover withholding taxes.

The basic mechanism for cross-border arbitrage in the example above is that fund managers in the U.S. temporarily transfer ownership of shares (through equity lending) to an entity in Canada, which is not subject to withholding, then transfer the shares back after the dividend record date.

It means that the $1.00 dividend is paid to the Canadian entity rather than $0.85 to the U.S. entity. In practice, the two sides share the $0.15 savings in withholding tax which has been reclaimed through arbitrage, Christoffersen says. Her research shows that in this example the Canadian entity would on average receive about $0.05 per share and the U.S. firm $0.10 per share.

This form of dividend arbitrage is known as cum-cum trading (from the Latin for “with-with”) and while this type of trade was at one point considered legitimate, it has increasingly become a legal grey area where governments are calling it a form of tax abuse if the purpose of the trade is solely to avoid withholding taxes.

Christoffersen’s research shows an upside to the arbitrage for mutual funds that mix non-taxable (i.e. 401K or RRSP) and taxable monies. Taxable accounts can claim a tax credit for withholding taxes paid but the non-taxable accounts cannot, placing them at a disadvantage. Her research found that the more non-taxable money that mutual fund managers handled, the more likely they were to engage in cross-border dividend arbitrage. “It showed that managers were acting in a way to mitigate tax implications for their non-taxable investor base,” she says. Cross-border dividend arbitrage was being used to avoid withholding taxes that were inefficiently being applied across tax groups.

Why are European countries going after firms over dividend arbitrage?

The cases that triggered the most recent prosecutions in Europe involved strategies that went far beyond tax avoidance and moved into tax fraud.

In several countries, investors rapidly bought and sold shares around the dividend record date to make it appear as though the same shares had multiple owners each with rights to a dividend tax credit or tax refund, Christoffersen says. Pension funds were found to be particularly active because the active trading on the dividend record date made it look like they were the owners of record , and so were eligible to apply to the tax authorities for a tax refund. Through complex and rapid buying and selling and short-selling arrangements, multiple parties claimed they were entitled to a refund of withholding taxes on a single dividend payment.

As a result, governments reimbursed taxes on the same dividend many times over.

This practice, known as cum-ex trading (“with-without”), is what authorities say was illegal.

“Even though there was only one dividend payment, you might have five different entities reclaiming a tax credit from the government, and a dividend payment can only have one potential credit associated with it,” Christoffersen says.

How are governments responding?

European countries have reported huge tax losses linked to cum-ex trading, which largely took place in the 1990s and 2000s before authorities began cracking down around 2012 – though investigations continue. The scandal has been described as Europe’s largest tax fraud. Across Europe, total losses have been estimated at €55 billion (CAD$88.7 billion).

Germany and Denmark have led enforcement efforts, Christoffersen says, while other nations have also tightened rules around share lending, tax refunds and dividend payments.

“Governments had to clamp down,” Christoffersen says, “because huge amounts of money were being taken from tax authorities.”

What does this mean for firms, governments and investors?

Europe’s experience has pushed other governments to take a closer look at cross-border dividend arbitrage. Withholding taxes on foreign investors are a source of revenue for countries. When dividend arbitrage reduces those taxes, governments may see it as lost income.

Tax rules differ by country, and Canada and the U.S. have not pursued criminal investigations into dividend arbitrage to the same extent as European countries.

Still, North American firms have faced scrutiny. In October, Dutch authorities said they planned to question the Healthcare of Ontario Pension Plan, alleging the fund avoided paying €200 million (CAD$322.6 million) in taxes. HOOPP denied the allegation. In September, German prosecutors searched the Frankfurt offices of Toronto-based Maple Financial Group over dividend arbitrage strategies. The bank said it’s co-operating with investigators.

Christoffersen says Europe’s experience exposed weaknesses in enforcement. “There should have been a way to track that only one tax refund was issued for each dividend payment,” she says.

Is dividend arbitrage a good or bad strategy?

That depends on which version you mean.

Classic dividend arbitrage – buying and selling shares around dividend record dates – comes with clear risks. There is no guarantee that a stock’s price will fall by less than the dividend being paid, Christoffersen notes.

If a stock dropped from $100 to $98.90 after collecting a $1.00 dividend, the investor would lose $0.10 per share, even before transaction costs and taxes. Successful dividend arbitrage requires deep research and a thorough understanding of market movements – another reason this tactic is meant for large, sophisticated investment firms rather than armchair traders.

And while the cum-ex strategies seen in Europe are illegal, the cum-cum cross-border dividend arbitrage that Christoffersen studied can benefit retirement accounts.

“In our research, we saw retirement money, such as 401(k) plans, that couldn’t claim tax credits because it was mixed with other taxable accounts,” Christoffersen says. “In those cases, dividend arbitrage actually helped ensure pension money wasn’t taxed unnecessarily.”