The EU FTT: A seismic effect on global financial markets?
If an EU FTT along the lines proposed by the European Commission were to be introduced into law, this would have enormous repercussions for global financial markets, argue Mark Persoff and Rod Roman of Ernst & Young.
On February 14 2013, the European Commission published a revised proposal for a broad-based financial transaction tax (FTT) to be applied by 11 EU member states (the EU 11). This article sets out:
A brief history of the EU FTT proposal;
The basic structure of the proposed tax;
The principal consequences for global financial markets if the proposal were introduced in its current form; and
An assessment of whether the proposal will be introduced into law – and if so possible changes which may be made.
In September 2011, the Commission set out in a draft Directive its proposal for an FTT across all 27 EU member states.
However, the proposal could only be introduced into law if all member states were in agreement. It became obvious during the first half of 2012 that the UK (and other member states) would not agree.
In the autumn of 2012, the EU 11 – led by France and Germany – asked the Commission to take forward an FTT proposal to be introduced only by those countries under a little-known procedure known as enhanced cooperation. This procedure effectively enables a "coalition of the willing" to sidestep the need for unanimity among all 27 EU member states.
On January 22 2013, the European Council authorised the enhanced cooperation process in respect of the EU FTT (with the UK and some other member states abstaining). On February 14 2013, the Commission adopted a proposal for a Directive implementing enhanced cooperation in respect of the FTT.
Separately, over the course of 2012, both France and Italy announced the introduction of an equities FTT. In August 2012, France went live and Italy followed in 2013 (March for equities and July for equity derivatives).
The policy drivers underpinning the Commission's proposal are to:
Harmonise transaction taxes within the EU (especially among the EU 11);
Ensure the financial sector pays a fair and appropriate amount of tax; and
Penalise transactions that are perceived to increase financial stability risks.
The Commission estimates that the FTT (introduced by the EU 11) would raise approximately €31 billion ($41 billion), even allowing for a 15% reduction and 75% reduction in the volume of, respectively, equities / bonds trading and derivatives trading, and have also said that it sees a successful EU 11 FTT as a precursor to a global FTT.
Proposed EU FTT: Basic structure
The Commission's draft Directive is very similar to the original EU FTT proposal of September 2011. The Commission's express wish is to apply the tax to "all actors, all instruments and all markets".
The proposed EU FTT differs from typical transaction taxes in a number of fundamental ways:
Persons in scope
Most transaction taxes apply only to the buyer. The EU FTT applies to all financial institutions (FIs) party to a transaction. The definition of an FI is very wide and covers banks, insurance companies, asset managers, funds and brokers. It also includes pension funds and potentially treasury and holding companies of non-financial groups. Accordingly, the EU FTT is potentially due from both parties (buyer and seller) to a transaction.
Scope of instruments
Most transaction taxes apply only to equities. The EU FTT applies to all secondary market transfers of equities, bonds and entry into (as well as secondary market transfers of) all derivatives, as well as stock loans and repos. It also applies to intra-group transfers of risk with respect to such instruments. Material modifications of in-scope instruments are also treated as taxable transactions.
Basis of taxation
The EU FTT applies only to FIs established in an EU 11 jurisdiction. However, the definition of "establishment" is surprisingly broad and without precedent, and will be met if an FI meets any of the following conditions:
It has been authorised by the authorities of that member state to act as such, in respect of transactions covered by that authorisation;
It is authorised or otherwise entitled to operate, from abroad, as financial institution in regard to the territory of that member state, in respect of transactions covered by such authorisation or entitlement;
It has its registered seat within that member state;
Its permanent address or usual residence is located in that member state;
It has a branch within that member state, in respect of transactions carried out by that branch;
It is party (or acting for a party) to a financial transaction with another person established in that member state pursuant to the above points (the counterparty rule);
It is party (or acting for a party) to a financial transaction over (broadly) bonds or shares issued, or an exchange traded derivative treated as issued, within the territory of an EU 11 member state (the issuance rule).
The inclusion of both the counterparty rule and the issuance rule is particularly controversial, as illustrated by the following:
Example 1: Counterparty rule
A US FI enters into an over the counter derivative contract with a French corporate client.
The US FI is liable to the EU FTT merely because its counterparty is located in France. If the French corporate client is also an FI, it will also be liable to the EU FTT.
Example 2: Issuance rule
A US FI acquires a German corporate bond from a UK FI. Other than the subject matter of the transaction, neither the US FI nor the UK FI has any nexus with Germany.
The US FI and the UK FI are each liable to the EU FTT merely because the financial instrument that is the subject matter of the transaction is a German corporate bond.
Gross basis of tax
In contrast to the French FTT and Italian FTT, the EU FTT applies on a gross basis; the tax base is not capable of being reduced by set off or netting.
In contrast to most transaction taxes, the EU FTT has practically no exemptions.
In particular, there are no exemptions for market makers, brokers or other intermediaries, for investors such as pension funds, or for short term / financing transactions such as repos or stock loans. (With respect to the last point, the only concession is that stock loans and repos are each taxed as one, rather than two, transactions.)
There is no exemption for intra-group transactions.
There is no blanket exemption for agents. There is only a limited exemption where one FI acts as agent for another FI.
The absence of exemptions, in particular for market makers / intermediaries, means that the tax may potentially produce a cascade effect which could be up to 100 basis points for each trade as transactions are routed through a chain of FIs in a sale between the ultimate seller and the ultimate buyer.
The EU FTT does not harmonise tax rates. It only provides for minimum rates to be applied by the participating member states: 10 basis points for bonds and shares and 1 basis point (based on notional) for derivative contracts.
The EU FTT Directive contains a very wide-ranging general anti-abuse rule. It also has a specific anti-abuse rule targeted at transactions over depositary receipts.
Payment / collection
The tax is due instantaneously where the transaction is undertaken on an electronic platform and within three days for non-electronic trades.
Joint and several liability
Both parties are jointly and severally liable for tax due from the FI. If the parties are both FIs, they are both jointly and severally liable for each other's primary liability. In addition, other persons, including market infrastructure participants (for example exchanges and clearing houses), may also be made jointly and severally liable.
Principal consequences for global financial markets
The impact of the current proposal on global financial markets would likely be seismic.
This is illustrated, for example, in a recent report which suggests that the EU FTT (if applied in its current form and before allowing for inevitable behavioural changes) would raise approximately €170 billion from 42 leading European banks if applied to their 2012 business models. This would equate to approximately 92% of their 2015 estimated profits before tax. The same report estimates (on the same assumptions) that European fund managers could face an annual EU FTT bill of €17 billion, with investors based in the EU 11 paying an effective tax of 17-23 basis points on their equity and bond portfolios.
As noted in the report, were the proposal to survive in its current form, the impact for market participants means that significant behavioural changes would be inevitable.
Changes might include:
Subsidiarisation of non-EU 11 branches of EU 11 domiciled entities;
Repo activity moving to collateralised lending and / or repo funding with ECB and other central banks (which are exempt from the EU FTT);
Moving from a title transfer collateral model to a pledged collateral model;
Shortening of transaction chains to reduce the cascade effect of the EU FTT;
Hedging moving from physical transactions to derivative transactions, to reduce a 10 basis point charge to a one basis point charge on the hedge;
Transactions moving from being on-exchange (and thus potentially within scope of the issuance rule) to over the counter;
Restructuring of groups to minimise the incidence of intra-group transactions, which may look for ways to move from multiple entity structures to branch structures; and
FIs (and investors), especially if domiciled outside the EU 11, looking to replace EU 11 securities with non-EU 11 securities wherever possible, to fall outside the application of the issuance rule.
EU FTT proposal: possible outcomes
The draft Directive envisaged that the EU FTT would go live on January 1 2014.
However for the draft Directive to be passed into EU law, it must be agreed unanimously by the EU 11.
There have been intensive discussions between the EU 11, the other member states and the Commission since the draft was published in February. Current indications are that progress is slow, and that a January 1 2014 start date is not realistic. The German finance minister recently implied that the EU FTT was unlikely to operate before 2015, noting that the tax "will not be a major concern for this year and next year". Germany's position is critical to the outcome for the EU FTT, particularly with respect to whether the German government contains coalition partners who insist on the introduction of a broad-based EU FTT. This will rest on the result of their parliamentary elections in September 2013.
Matters have been further complicated by the UK challenging the legality of the EU FTT before the European Court of Justice. The UK's principal complaint is that the EU FTT operates in a manner which is extra-territorial, and thus contrary to EU law, insofar as it fails to recognise the competences, rights and obligations of those member states outside the EU 11.
At this point in time, and given legal and political uncertainties, it would be extremely brave to predict the precise outcome of the EU FTT project.
We are of the view, however, that the most likely outcome is that the EU 11 will wish to introduce the EU FTT sometime in 2015, and that the current proposals may be significantly revised to accommodate many of the concerns that have been raised by business in general (both inside and outside the financial sector).
Member states will likely focus on the following issues in particular:
Amending the establishment rule; this might be done by removing (or downgrading) the counterparty rule or, more fundamentally, by effectively replacing the current establishment rule altogether with an issuance rule (similar to those operating in the context of UK stamp duty reserve tax, French FTT and Italian FTT);
Excluding fixed income instruments – especially government bonds;
Excluding repo and stock loans; and
Introducing a market maker exemption, an exemption for pension funds and an exemption for intra-group transactions.
In the event that the EU FTT project were to fall apart, either because of political disagreement or the UK's legal challenge, individual member states may decide to follow the lead of France and Italy and introduce their national FTTs; and France and Italy may be minded to extend the scope of their existing FTTs.
A valuable window
The landscape for the EU FTT is uncertain. However the likely delay to the EU FTT legislative timetable will provide the financial services community with a valuable window to enter into intensive engagement with government, and to work up strategic solutions to the commercial and operational challenges posed by the EU FTT.
Ernst & Young
Tel: +44 (0) 20 7951 9400
Mark is a tax partner in Ernst & Young's financial services practice. He was previously a tax partner at a magic circle law firm and has specialised in international and European taxation issues, particularly for financial institution clients, for more than 15 years. Mark has been heavily involved in advising clients, including banks and asset managers, on recent financial transaction tax developments in Europe for the last 18 months, and has spoken and written widely on the subject. Mark has been ranked as a leading tax adviser by publications such as Legal 500, Chambers & Partners and the World's Guide to the Leading Tax Advisers.
Ernst & Young
Tel: +44 (0)20 7951 1549
A partner since 1996, in his current role Rod leads Ernst & Young's banking tax practice. He is a chartered accountant and corporate treasurer and a specialist in the taxation of debt, equity and derivatives. He is Ernst & Young's lead partner on financial transaction taxes leading a network of professionals on EU FTT both across the 11 member states and with the major global financial centres.