Cross-Border Investing with Tax Arbitrage: the Case of German Dividend Tax Credits

German dividends typically carry a tax credit which makes the dividend worth 42.86% more to a taxable German shareholder than to a tax-exempt or foreign shareholder. As a result of the credit, the ex-dividend-day share price drop exceeds the amount of the dividend. I document that the ex-day drop reflects approximately one-half of the tax credit, and show that futures and option prices embed approximately one-half of the tax credit. The existence of the tax credit creates possibilities for cross-border tax arbitrage and also has implications for market integration, market efficiency, tax policy, and tax-efficient foreign investment. In particular, it is tax-efficient for foreign investors to hold DAX index futures rather than investing directly in the DAX cash index.