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The German Tax Trade
By Paul Amery | 17 June, 2010 15:34 (GMT)   

As the heavy recent turnover in three German-domiciled equity funds demonstrates, ETFs can have other, short-term applications of a very different character.

The chart below shows the combined assets under management during the last two months of three German ETFs: the iShares DAX (DE) and DivDAX (DE) funds and the ETFlab DAX fund. All three are classified as German “KAGs” (Capital Investment Companies) and all three use physical (in specie) replication to track their respective indices.

DAX_ETF_AUM

The chart shows striking fund inflows and outflows over the last several weeks, with the combined assets of the three funds more than trebling in early May, only to fall back again thereafter. There are several other “minor” peaks in assets over the period.

Though several market participants did not want to discuss the German tax trade, a few market makers were prepared to explain how it works. The fund flows are driven by three main factors, they said: the tax-exempt status of German KAGs for domestic investors; a rule-based approach to taxation by the German authorities that does not “look through” to the motivation of investors when contracting securities lending deals; and the German dividend payment season that is concentrated in late spring.

As shown in the table below, which lists the largest ten stocks in the DAX index with their weightings, yields and ex-dividend dates, seven of the ten go ex-dividend in April and May. And if you compare the dates in the last column of the table with the peaks in ETF assets in the chart above, you’ll see that the largest fund inflows coincide with the dates when certain index stocks went XD. In particular, the jump in the combined ETF assets from €3.7 billion on 5 May to over €12 billion on 6 and 7 May appears to have been motivated by a desire to own the ETFs over the XD dates for Allianz and E.ON, two of the DAX’s biggest dividend payers (though why there wasn’t a similar spike in assets over the XD date for Deutsche Telekom, the highest-yielding stock of the top ten, is unclear).

DAX Component

Index Weighting (%)

Yield (% p.a.)

XD Date

Siemens

10.6

2.05

27/01/2010

E.ON

8.9

6.17

07/05/2010

BASF

8.0

3.66

30/04/2010

Bayer

7.5

2.90

03/05/2010

Allianz

7.3

4.82

06/05/2010

Daimler

6.6

-

-

SAP

6.1

1.35

09/06/2010

Deutsche Bank

5.7

1.50

28/05/2010

Deutsche Telekom

5.7

8.12

04/05/2010

RWE

4.6

6.07

23/04/2010

A securities lending transaction is structured legally as a change in ownership (with an obligation to reverse this change in ownership at some future point). Therefore a foreign investor owning a German stock that is about to pay a dividend can avoid paying the full withholding tax by lending his stock to a German-domiciled ETF (which can receive the dividend payment gross of tax). From the point of view of the German tax office, the investor has sold his dividend-paying stock to the fund.

The ETF in turn lends the investor a basket of equities that are not due to make any payments over the holding period. The terms of the loan benefit both parties: the ETF gives the investor a better tax treatment than he would normally receive, while the investor pays the ETF’s manager a fee for the transaction that it would not otherwise get. This fee is split between the manager and the fund.

The third part of this transaction involves potentially very large cash inflows to the ETF for a short period, often only a few days, as we can see in the chart above. Since the ETF will usually have a restriction on how much it can lend to any one counterparty (for the iShares DAX (DE) ETF it’s 10% of the fund’s value), the larger the fund’s size, the larger the lending transaction can be.

If this sounds like a free lunch it’s important to remember that there’s a loser in this packaged trade – the German tax authorities. One Frankfurt-based lawyer I spoke to told me that in general, in his opinion, securities lending transactions are not motivated by tax considerations. For the three ETFs we’ve looked at here, however, it’s hard to think of any other reason why assets under management should suddenly jump during the German dividend payment season, only to fall back afterwards.

As is common with securities lending transactions undertaken in ETFs, there’s very little detail given of what’s actually going on. Investors can check the statement of income given in the annual report and accounts to see how much lending the fund has been doing, the counterparty exposure limits set out in the fund prospectus, and policy statements on how collateral is managed. But there’s no disclosure of the other counterparties in these tax-related transactions, who are likely to be banks (who else would be sitting on billions of euros of inventory in dividend-paying German stocks?). Some additional information on who else is involved in such trades surely wouldn’t go amiss.

Whether tax loopholes such as these (which are perfectly legal, I should add) can survive amidst the current scramble by governments for revenues is another matter.

 

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