By Paul White

In a recent Project Finance NewsWire, we highlighted European Union proposals for the introduction of a financial transaction tax on a range of common financial trades and warned of the potential for US and other non-European financial institutions to be subject to the tax.

At that time the proposal warranted only a mention in the “In Other News” section because continued opposition from The Netherlands, the United Kingdom and Sweden made adoption of a financial transactions tax or FTT unlikely given that any dissenting member state might effectively veto the initiative.

While that remains true, a significant group of member states may move ahead with an FTT within its own borders.

Ten countries — Austria, Belgium, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain, all of which have adopted the euro as their single currency — have proposed that the FTT project be advanced by way of “enhanced cooperation.” This is a little-used EU legislative procedure that would effectively side step the veto roadblock and allow the 10, and any other member states that opt in, to adopt an FTT without binding the dissenting member states.

Last month the European Commission agreed to recommend “enhanced cooperation” to the EU Council and the European Parliament so the introduction of an FTT in 2014 is now significantly more likely to occur, at least within the eurozone.

In that event, other member states may reassess their opposition to the tax.

If the UK, for example, remains outside the FTT area, the City of London will still be affected by the charge at the non-UK end of EU cross-border transactions while the UK Exchequer would miss out on the revenue-raising benefits of the new tax. So if, as now seems inevitable, the UK is unable to block an FTT completely, pragmatism may dictate that it work within the EU to mitigate the potential effect of the tax on its financial sector, possibly even to the extent of opting in.

This article discusses the declared purposes of the FTT, the details of the FTT that have so far been published and explains why even financial businesses that are not active in Europe need to be aware of the potentially global reach of the proposals.

Why an FTT?

In order to appreciate the details of any tax, it is useful to have an understanding of the underlying policy, but the objectives of the FTT remain confused.

Direct taxes generally fall into one of three categories. Most are simple revenue-raising taxes by which governments finance their activities from a levy on the revenue, income, profit and gains of individuals and businesses who are resident in their jurisdictions or otherwise carry out taxable transactions. Such revenue taxes are behaviorally neutral for the majority of taxpayers who do not have the luxury of choosing their tax residences to minimize their tax bills. As such, they may be contrasted with what one might call “carrot and stick taxes.”

“Carrot taxes” are those tax rules that seek to encourage specific activity and, as such, they are particularly susceptible to changes in government or political priorities. Probably the clearest example of “carrot taxes” in recent years has been the fiscal treatment of renewable energy expenditure in many developed countries.

By contrast, “stick taxes” reflect a policy of discouraging the taxed behavior, punitive duties on tobacco products and alcohol being obvious examples.

Although these three groupings are generally mutually exclusive, the published policy objectives of the proposed FTT suggest that it somehow manages to straddle all three categories.

The September 2011 “Proposal for a Council Directive in Relation to FTT” says that “the present proposal is a first step... to avoid fragmentation in the internal market for financial services ... ensure that financial institutions make a fair contribution to covering the costs of the recent crisis ... [and] create appropriate disincentives for transactions that do not enhance the efficiency of financial markets thereby complementing regulatory measures aimed at avoiding future crises.”

It is frequently said that an FTT is a “Tobin tax” and, if true, that would place it firmly in the “stick tax” category. When James Tobin, winner of the 1981 Nobel prize for economics, proposed a tax on currency exchange transactions, it was to discourage currency speculation after the Bretton Woods system of money management ended in 1971. He subsequently explained the theory as follows:

The idea is very simple: at each exchange of a currency into another, a small tax would be levied — let’s say, 0.5% of the volume of the transaction. This dissuades speculators as many investors invest their money in foreign exchange on a very short-term basis .... My tax would return some margin of maneuver to issuing banks in small countries and would be a measure of opposition to the dictats of the financial markets.

Commenting on the recent decision of 10 eurozone members to forge ahead with the FTT, the Paris-based news agency “France 24” referred to it as an agreement “to impose a tax on financial transactions in the hope of curbing risky, speculative trades.”

It is ironic that this justification for the introduction of an FTT fails to recognize that many of the derivatives to which it will apply are actually designed to hedge risks that would themselves be outside the FTT. So, if a hedging derivative becomes too expensive because of the FTT charge, the tax may actually increase the level of risk in global markets.

As explained below, the current FTT proposals have the general character of a Tobin tax, but with the key difference that they do not, in fact, target risky transactions but have a broad application to financial trades. Therefore, the FTT is similar to a transfer tax like the stamp duty on most share sales that applies in the UK. This makes it more like a simple revenue tax.

The perception of the FTT as a revenue tax is also supported by the second objective of levelling the playing field between financial institutions and other businesses. As the economic recovery drags on, there is continued widespread anger in Europe at the role of financial institutions in bringing about the crisis. It is arguable that one aim of the FTT is simple retribution, to make the banks pay more than their current share of tax as recompense for the costs incurred by governments in cleaning up the mess perceived to have been caused by the banks.

Finally, some proponents of an FTT may even view it as a “carrot tax,” although it is not immediately obvious how the imposition of an FTT might be a step to avoiding fragmentation of the financial services market. One person’s “fragmentation” is another’s “fair competition.” The FTT proposals have been widely condemned in the UK as undermining the competitiveness of the European financial markets compared with New York and other non-EU financial centers. The UK government opposes the introduction of the tax because it fears that it will result in transactions being diverted from the City of London to non-EU financial markets. The stark reality is that, purely from a self-interested perspective, member states that have strong financial sectors are likely to seek more fragmentation rather than less.

How It Would Work

Although the published proposals for an FTT are fairly detailed, a number of key aspects - for example in relation to collection - remain incomplete, and they may change significantly before the tax is eventually introduced.

However, what is clear is that the FTT is intended to have a wide scope, focused on financial transactions carried out by financial institutions acting either for their own accounts or for, or in the name of, another party.

The “financial institutions” to which the tax will apply are defined to include investment firms, credit institutions, insurance and reinsurance undertakings, UCITS (undertakings for collective investments in transferable securities), certain special-purpose vehicles and, of course, banks.

“Financial transaction” is also broadly defined and includes the purchase and sale of a “financial instrument” before netting and settlement (including repos and securities lending and borrowing), the transfer of risk in “financial instruments” between group members and the conclusion or modification of derivative agreements.

Although the FTT was proposed as a disincentive to “transactions that do not enhance the efficiency of financial markets,” this is not reflected in the definition of chargeable “financial transactions.” If the FTT is to be a Tobin tax, it should apply only to those transactions that are inherently risky or are otherwise to be discouraged perhaps, for example, certain unhedged derivatives and short sales. However, the proposals do not distinguish trades in these terms so the FTT will apply to vanilla transactions in bonds (excluding primary market issuance and bank loans) and shares as well as derivatives.

Rates will be set by member states, but it has been recommended that share and bond transactions should be taxed at 0.1% of the higher of consideration and market value and derivatives at 0.01% of the notional amount.

Who Will Have to Pay

When details of the proposed FTT were first published in September 2011, the identification of chargeable financial institutions relied exclusively on a residency or establishment principle. Financial institutions acting through offices in a member state charging FTT would, of course, have to pay the tax. But further extension was needed to prevent EU-based users of financial services avoiding the costs of the FTT simply by transferring their financial transaction business to non-European financial institutions, and this was proposed to be addressed by a mechanism for deeming a non-EU institution to be established in the charging state.

  Under the extended establishment principle, in order for FTT to apply to a financial transaction, at least one party to the transaction must be a financial institution established, or deemed to be established, in the European Union. The concept of deemed EU establishment extends the charge to financial institutions that do not have EU branches in any cases where they enter into a financial transaction with an EU counterparty.

Where the establishment principle applies, at least one party will actually have to have an EU establishment for the FTT to be chargeable. If the financial institution does not have an EU establishment, both it and the non-financial institution EU counterparty are to be jointly and severally liable to pay the FTT. If the financial institution fails to pay, then the relevant member state would be able to collect from the counterparty in its jurisdiction. Of course, in practical terms the possibility that a non-financial business in the EU would be secondarily liable for tax unpaid by a non-EU bank on a simple on-marked trade raises a plethora of contractual, risk, liability and enforcement issues.

In April 2012, it was proposed to add a second test, an “issuance principle,” for identifying chargeable financial institutions in addition to the establishment principle.

The “issuance principle” would expand the FTT charge to include transactions between entirely non-EU parties if the securities being traded are issued by a company in a member state that has opted for an FTT. Unfortunately, the information so far available about the extended ambit of the FTT does not explain how a member state would enforce the tax where neither party is established anywhere in the European Union. Apparently this proposed extension of the FTT takes its inspiration from the UK stamp duty and stamp duty reserve tax regimes, but the reason those charges work is because UK shares are registered instruments and a transfer cannot be registered unless duty has been paid.

The Future

It is likely that led by France and Germany a significant minority, and potentially a majority, of EU member states will introduce an FTT.

Under current proposals, FTT will be charged when at least one party to the financial transaction or the issuer of the traded assets is established in a charging member state.

Although considerably more work will be needed to finalize the FTT charging and collection regime by the proposed
January 1, 2014 start date, the major eurozone states have demonstrated a commitment to forge ahead with the project and that may prove a game changer for states that, until now, have opposed the introduction of an FTT.