The ‘ex-dividend day’ is the date on which stocks start trading without the value of their next dividend payment, which generally reduces their price since equity is paid out. Investors tend to engage in abnormal trading on this date, leading to unusual trading patterns.

Previous research shows that abnormal trading and stock price behaviour around ex-dividend days can be explained by tax preference and tax heterogeneity among investors – whereby different investors will be party to various tax rates and structures.

However, in a recent paper, Moritz Wagner and Xiaopeng Wei sought to understand whether this can fully explain the phenomenon. They focus on whether ‘cum-ex’ trading may also play a role.

Cum-ex trading is a practice in which stocks are quickly traded around the ex-dividend day, with and without dividend rights. This obscures who the actual owner of the stocks is, and tax authorities are unable to follow these rapid changes in ownership.

These transactions usually take 2 to 3 business days to complete, at which point the stocks are delivered to the buyer. When stocks are sold close to the ex-dividend day, the transfer date can coincide or overlap with the ex-dividend day, meaning that the stocks are sold with their dividend value but delivered without them.

As explained by Wagner and Wei, the standard clearing process ensures that the buyer receives the stocks at the ex-dividend price. The company that pays the dividend usually withholds the tax and transfers it to the central or governmental treasury, while the certificate for tax reimbursement is or was issued by the shareholder’s bank.

In a common form of cum-ex trading, however, the stock is not actually owned by the seller. Rather, the seller is short-selling the stocks, meaning that they have borrowed shares from a broker to sell them to a buyer who takes part in the scheme.

Since neither the seller’s bank nor the owner’s bank recognises this as a short sale, aware or unaware of the nature of the transaction, they both issue a tax certificate, although only one of the two shareholders actually paid withholding tax. In a final step, the buyer sells the stocks back to the short seller, who transfers the shares back to the original owner. The proceeds from the additional tax refunds are then shared among the parties.

This obfuscation of ownership allows networks of banks, brokers, hedge funds and law firms to obtain multiple tax refunds on taxes that have been paid just once or not at all. Ultimately, it provides an opportunity for some investors to earn short-term profits at virtually no extra risk, to the detriment of all other investors and society as a whole.

This practice evolved largely from well-known but ignored flaws in the tax structures of European countries. Despite warnings from whistle-blowers as early as 1992, the practice continued, with some banks setting up entire divisions specifically to offer cum-ex trading to high net-worth investors.

Subsequent investigations have identified hundreds of companies allegedly involved with suspicious transactions and several trials have been started or were pending at the time of Wagner and Wei’s research.

Tax authorities and lawmakers have generally acted very slowly upon numerous warnings. Germany has introduced laws to tackle cum-ex trading and has strengthened its legislation over time. However, surprisingly, no EU-wide coordinated efforts have been introduced.

So, how significant is the effect of ex-cum trading?

Using current market data from a range of European countries identified as potentially affected by cum-ex trading, Wagner and Wei analyse the scale of this issue.

Their study includes data from a sample of 4,295 firms and 34,564 dividend events. They also develop a two-stage regression approach to disentangle the effect of cum-ex trading from alternative explanations for the increase in trading volume around the ex-dividend day.

Before examining the extent of cum-ex trading in all countries, they used the case of Germany as an experiment to test the effectiveness of the proposed approach. As Germany has introduced laws to curb cum-ex trading, it can act as a natural control to ensure the research methodology is appropriate.

Once they determined that it is, the researchers examined the identified countries with potential cum-ex trading activity to estimate the associated cost. Theirs is the first academic study to formally estimate the tax loss from cum-ex trading across different countries.

The results suggest that European countries were or still are significantly affected by cum-ex trading. This is especially true for Denmark and Germany, where the practice has been widely reported. However, there is also considerable cum-ex trading in countries that have received less attention, such as Finland, Norway, and Spain.

This has led to a substantial loss in tax revenue for treasuries due to illicit refunds. The researchers report a conservative estimate of around 13.2 billion euro of tax revenue losses between January 2002 and August 2018.

So, why is this important?

Perhaps most obviously, but also most importantly, loss of tax revenue means that less public funding is available. This can lead to a reduction in all areas of government spending, which has ramifications across the entire society. This is particularly significant, considering that most countries run long-term budget deficits.

It is, perhaps, shocking that this practice has been known about for many years. Despite widespread knowledge of illicit trading activities, lawmakers have been slow to act. This has allowed pilfering of public funds, costing treasuries and citizens significant amounts of money.

The research conducted by Wagner and Wei highlights the importance of this issue. Recent court rulings have confirmed that cum-ex trading schemes are illegal and should not have been allowed to continue. If cum-ex trading is to be stopped, the researchers argue that tax loopholes need to be closed, and strong frameworks to prevent wrongful tax refunds should be introduced, as some countries have already done successfully.