Cross-border investing with tax arbitrage: The case of German dividend taxcredits

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.