German dividends typically carry a tax credit which makes the dividend wort
h 42.86% more to a taxable German shareholder than to a tax-exempt or forei
gn shareholder. This results in a penalty for foreign investors who buy and
hold German dividend-paying stocks. I document that, as a result of the cr
edit, the ex-day drop exceeds the dividend by more than one-half of the tax
credit, and show that futures and option prices embed more than one-half o
f the tax credit. The existence of the credit creates opportunities for cro
ss-border tax arbitrage-in which foreign holders of German stock transfer t
he dividend to German shareholders-and implies that it is tax efficient for
foreign investors to hold derivatives rather than investing directly in Ge
rman stocks. The empirical findings are consistent with costly tax arbitrag
e activity by German investors, who face tax risk due to antiarbitrage rule
s. Since dividend tax credits exist in many other countries, the findings a
re potentially of broad interest.