Germany attacks 'illegitimate' dividend tax avoidance scheme

* Report highlights German loophole used by investors

* German government attacks 'illegitimate' scheme

* Commerzbank says to stop such services (Adds detail, background, comment)

By Arno Schuetze

FRANKFURT, May 3 (Reuters) - The German government has again criticised schemes to help foreign institutional investors avoid a dividend withholding tax, following new media allegations of their widespread use, with Commerzbank pledging on Tuesday to stop offering such services before the tax loophole is blocked by a new law.

Under current German law domestic funds can claim a credit on a 15 percent withholding tax paid on dividends which foreign funds cannot.

But a joint media investigation alleged that major funds were deliberately seeking to avoid paying the tax by lending their shares 'cum dividend' to German banks and investment funds who could make use of the dividend tax credit and taking them back days after the dividend is paid, leaving the shares entitled to the next dividend.

Newspapers Handelsblatt and the Washington Post, German public TV station Bayerischer Rundfunk and investigative journalism group ProPublica said they had uncovered the avoidance scheme in a cache of confidential documents which had been obtained by ProPublica, including emails, marketing materials, chat messages and other communications among participants in the schemes.

They said the documents also showed the loophole in German tax rules had been exploited by some of the world's largest institutional investors including Blackrock and Norway's sovereign wealth fund to cut their tax bills.

The report reignited a debate about tax avoidance in Germany, where politicians and government rounded on a scheme that Wolfgang Schaeuble's finance ministry dubbed illegitimate, even if it was not illegal.

They concluded that banks including Germany's Commerzbank and Deutsche Bank arranged the widely used tax-avoidance scheme dubbed 'dividend stripping' or 'cum cum' trades, costing the tax payer 5 billion euros ($5.8 billion) in lost revenue since 2011.

"To make it clear: we consider the cum-cum deals illegitimate because their sole purpose is to avoid the legal taxation of dividends," a spokesman for Germany's finance ministry said.

That criticism was echoed elsewhere. "It simply can't be right that German banks are using tax loopholes to put billions of euros beyond the reach of the tax man," said Hans Michelbach, a senior German conservative lawmaker.

"This business must be stopped."

German Chancellor Angela Merkel's cabinet in February drafted a law to close the loophole.

Commerzbank, which is partly owned by the state, pledged to stop offering such tax deals in anticipation of the new legislation, Chief Financial Officer Stephan Engels said on Tuesday.

Blackrock declined to comment. A spokesman for Norway's national wealth fund said that securities lending was an important part of the fund's investment strategy but it did not participate in so called "dividend arbitrage" trading in Germany.

The fund added that it has outsourced the securities lending operation to an agent, whose actions are in compliance with the German legislation.

"We do not necessarily know the motivation for borrowing, or who the end user is, but are aware that tax considerations are one of several drivers for pricing these transaction," the spokesman said.

The media reports said that other major institutional investors including Fidelity Investments and Vanguard Group had made use of the loophole, while banks including SEB, Barclays, UBS, JPMorgan, Goldman Sachs , Morgan Stanley and Citigroup had helped.

All the banks declined to comment.

Vanguard said it only lent out securities in the ordinary course of its business.

"Vanguard, like many other mutual fund companies, has long engaged in securities lending - a widely accepted investment activity that Vanguard employs prudently to add value for our clients," a spokesperson said.

"Vanguard follows all applicable regulatory, tax, and legal standards related to securities lending in the markets in which our funds invest," the person added.

A spokesman for Fidelity said: "We take our responsibility towards fund shareholders very seriously and when our funds engage in securities lending, they do so for the benefit of fund shareholders and in accordance with all applicable laws, rules and regulations." ($1 = 0.8684 euros) (Additional reporting by Gwladys Fouche in Oslo, Sinead Cruise in London and Matthias Sobolewski in Berlin; Editing by John O'Donnell and Greg Mahlich)