Dutch Supreme Court goes back to roots of participation exemption

Trades by Dutch market maker

After being informed that a German chemical group (AG) would distribute a “super dividend” in 2007, a Dutch market maker started acquiring call options on AG shares that would, after exercise, result in it owning 5% or more of AG’s nominal paid-up share capital. Shortly before AG’s dividend distribution, the market maker short sold AG shares to third parties for a price that included the super dividend (cum dividend). Immediately after the dividend distribution, the market maker acquired additional AG shares (ex dividend) and exercised its call options (ex dividend). It used the AG shares it had acquired to comply with its obligations under the short sales. In addition, it made a profit by selling its remaining AG shares to third parties that were in a short squeeze.

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The market maker made a lot of money on these cum/ex trades by using a loophole in German tax and stock exchange regulations: it was not required to remit German dividend withholding tax to the German Tax Authorities, while the purchasers of the AG shares under the short sales were able to offset the German dividend withholding tax. For the enthusiast, a short numerical example:

1 AG share (cum dividend) = EUR 200

Purchase price of 1 share cum dividend under the short sales = EUR 200

German dividend withholding tax = ~EUR 20

Net substitution payment = EUR 80 (EUR 100 -/- EUR 20)

EUR 200 Purchase price of 1 share cum dividend under Short Sale -/- 

EUR 180 ( 1 AG share + EUR 80 net substitution payment) =

Cum/Ex Benefit: EUR 20

The purchasers under the short sales were willing to pay EUR 200 instead of EUR 180, because they could off-set the EUR 20 German dividend withholding tax against their income tax.

Supreme Court’s ruling

The market maker argued in the proceedings that the cum/ex benefit (EUR 20 in the above examples), as well as any gains made from the sale of shares to other third parties, were exempt from Dutch corporate income tax under the participation exemption. On this matter, the Supreme Court ruled that:

• Call options giving right to 5% or more of a company’s nominal paid-up share capital do not constitute a participation within the meaning of the participation exemption, if the option writer does not have the underlying shares at its disposal (beschikken over) at the time of entering into the option agreement; and
• The benefit from German cum/ex trades is not exempt under the participation exemption because it does not originate from an increase in the value of the underlying shares. Instead, in this case, the cum/ex benefit originated exclusively from a mismatch between the German tax and stock exchange regulations, which meant that the market maker did not have to pay German dividend withholding tax. The cum/ex benefit as such does not qualify as a benefit that the market maker obtained as a shareholder on account of (uit hoofde van) its participation in AG.

Answers and questions

In its ruling, the Supreme Court effectively determined that capital gains derived from the exercise of call options, which are acquired through option exchanges, can never benefit from the participation exemption, regardless of the nature of the capital gains. This is so simply because it is impossible for option holders to substantiate that the underlying shares that, at the time of exercise must be delivered, are actually at the option writer’s disposal at the time of entering into the option purchase agreement. This is because the identity of the option writer is almost always unknown.

But even if this identity were known, it would still be unclear what to do, as several elements of the ruling give rise to questions.

First, the Supreme Court ruled that the underlying shares which at the time of exercise must be delivered, must be at the option writer’s disposal when entering into the option agreement. It seems to follow from this wording that the option writer is not permitted to sell its underlying shares after entering into the option agreement and subsequently acquire new shares or call options to hedge its obligations under the option agreement. Does this mean that the option holder must substantiate that the option writer continued to have the underlying shares at its disposal until exercise?

Second, by stating that the option writer must have the underlying shares “at its disposal”, we assume the Supreme Court requires the option writer to have the power of disposal with regard to the underlying shares. Generally this implies that the option writer must own the underlying shares, but in some cases, such as in bankruptcy, ownership and power of disposal do not necessarily rest with the same person. The use of the term “disposal” could give rise to uncertainty. For example, if we were to buy call options from an option writer that does not own the underlying shares but, in turn, owns covered call options on these shares, could our call options constitute a participation?

Third, the Supreme Court does not clarify whether the Falcons case requires the option writer itself to have a participation in the company. The ruling leaves room for interpretation. The Supreme Court on the one hand states that, pursuant to the Falcons doctrine, the option writer and the option holder can apply the participation exemption if the interest in shares that form a participation is split between them, but then goes on to conclude that the participation exemption does not apply if the option writer does not have the underlying shares at its disposal.

Further, the State Secretary of Finance stated in a decree of March 2020 that, in his opinion, the option writer must have a participation in the company. Whether the Supreme Court agrees with this view, remains unclear. If the requirement that the option writer must have a participation in a company applied, would this not lead to an unfair outcome? That is, an option holder not being able to apply the participation exemption when it acquires shares from:

• an individual that himself owns 5% or more of a company’s nominal paid-up share capital but does not have a participation, merely because individuals cannot have participations, or
• a non-Dutch option writer that owns 5% or more of a company’s nominal paid-up share capital, but cannot apply the participation exemption because it is not subject to Dutch corporate income tax in the first place?

Last, in its ruling the Supreme Court reiterates the importance of causality between the benefit obtained and the business activities of the underlying participation. Clearly, the cum/ex benefit lacked such causality. It is, however, a pity that neither the Court of Appeal nor the Supreme Court has provided clarity on whether this causality exists with regard to the profits obtained by the market maker from selling its additional shares to third parties that found themselves in a short squeeze. These profits may qualify as originating from a price fluctuation as a consequence of speculations. Although in earlier case law, the Supreme Court ruled that currency results – which are in no way related to the business activities of the underlying participation either – may benefit from the participation exemption, it has denied the applicability of the participation exemption to all benefits derived by the market maker by assuming all its profits originated from the cum/ex trades.

As noted, nearly 18 years have passed since the Falcons case, and who knows how much time will pass until the Supreme Court again gets the opportunity to end the uncertainties relating to option trade.